The Reckoning, Part II

In The Ring - February 3rd, 2023

Image: Shutterstock

(Note: Defcon website’s national debt page linked below)

“When debt/GDP is 125% as it is in the US, the only way out is a sustained period of significantly negative real interest rates to inflate the debt away…” Luke Gromen, January 27^th, 2023, in his Forest for the Trees newsletter

“The truth of the matter is that for different reasons we could have debt crises as early as the summer in the world’s three largest sovereign bond markets: the United States, Japan and Italy.” -Desmond Lachman, a former senior official of the International Monetary Fund (IMF), as quoted in the January 24^th Barron’s

(For those interested in a speed-read, we have emphasized the most important sections with bold font.)

---

For years, if not decades, one of the most perplexing government debt situations was in Japan. Despite monstrous deficits and banana-republic levels of indebtedness, interest rates fell to zero and, eventually, below. This spelled disaster for the legions of professional investors who shorted Japanese government bonds, assuming rates in the low single-digits could only rise. Their assumption was dead wrong and, as a result, many of them had near-death experiences, at least from a financial standpoint. In fact, this became known as the “Widowmaker” trade, so costly was its implementation.

The reason interest rates fell, even as Japan’s budget deficits gushed rivers of red ink, was due to consumer prices over there often dipping below zero as well. This condition was so intractable it became widely assumed that even the most aggressive monetary and fiscal policies couldn’t push inflation meaningfully above zero. Interest rates were similarly comatose. Even the above-referenced negative interest rates (monetary) and deficit spending (fiscal) that produced the rich world’s most indebted government — by far — weren’t able to create a whiff of inflation. But then came the pandemic.

As with most of the world, Covid initially created falling consumer and producer prices. The oil-market crash in the spring of 2020 was possibly the most graphic example of deflation during the pandemic’s early stages. However, as 2020 turned into 2021, inflation began to emerge around the world. By early 2022, it was glaringly apparent inflation was anything but transitory… even to America’s Federal Reserve.

As usual, Japan lagged behind most of the developed world in this regard, but its shift out of deflation into mild inflation became increasingly apparent. Regardless, the Bank of Japan (BOJ) doggedly maintained an artificial cap on 10-year Japanese government bond (JGB) yields of 0.25%, 25 basis points in Wall Street lingo. As inflation accelerated throughout 2022, sophisticated market participants, like hedge funds, began to bet against that cap by shorting vast quantities of JGBs. The “Widowmaker” trade was back.

Only this time, the loser became the BOJ. It was, and is, being forced to use its version of the Fed’s Magical Money Machine to fabricate trillions of yen in order to buy an equivalent quantity of JGBs at the mandated 0.25% yield level. (Please realize it takes 130 yen to buy one U.S. dollar, so it’s not as impressive as it seems; nevertheless, it amounted to real money — like $600 billion U.S. over the last two months. The BOJ now owns 70% of the entire 5- year and 10-year JGB markets.)

The BOJ’s version of Jay Powell, Haruhiko Kuroda, shocked markets in late December by lifting the yield ceiling to 0.50%. JGBs instantly rose to that rate, but the market is clearly signaling that it’s not high enough; the BOJ is once again being forced to squander commit immense sums to maintain that cap. One logical reason for this is that inflation is now touching 4%. Moreover, unlike with most of its developed-world peers, Japan’s CPI is still rising. Obviously, 0.50% long-term bond yields and 4% inflation are incompatible bedfellows. (By the way, sharp-eyed readers will notice the signal about higher inflation lying ahead when Japan’s CPI decisively broke above 1% last year. This is another example of the importance and typical accuracy of major range expansions.)

Chart: Evergreen via Gavekal

Mr. Kuroda retires this spring. His successor is making noises that the uber-easy money policies seen for as long as anyone can remember are numbered. Accordingly, the odds of the 0.50% rate cap holding are becoming longer and longer. This paradigm shift is among the most dramatic in a world filled with them. It’s my belief that markets still can’t quite fathom that the seemingly eternal status of zero, even negative, interest rates (and inflation at similar levels) in Japan is sayonara. What for so long appeared to be a bizarre, but permanent condition, now looks to be history.

In America, another strange but long-lasting phenomenon also seems to be nearing its sell-by date. It’s actually similar in key ways to what’s happening in Japan. The change catalyst is also a combination of rising inflation and massive government deficits. This is notwithstanding that inflation is cooling in the U.S., at least for now.

For decades, there have been fears that the U.S. government was on the brink of a financial crisis. As far back as the late 1960s, overseas governments, especially France, were complaining about the “exorbitant privilege” of America’s ability to run huge trade and budget deficits and settle those with dollars. This led some big-trade-surplus countries to ask that their accumulated dollars be exchanged for gold. At the time, this was still allowed by the U.S.

---

To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

---

By 1971, U.S. gold reserves were rapidly melting. This caused President Richard Nixon to close the gold window, effectively rendering the greenback a fiat currency. It was also a precipitating factor in the high inflation of that decade. It would take 20% interest rates under former Fed Chairman Paul Volcker to bring it to heel in the early 1980s at the cost of the worst recession, up to that point, since WWII.

Through the rest of the ‘80s, U.S. government deficits ran wild, despite a booming economy under Ronald Reagan. Consequently, the federal debt-to-GDP ratio dramatically worsened. In the ‘90s, though, a bipartisan (remember that term?) effort to rein in the red ink actually worked (another relic of the past). By the end of the last century/millennium, America was running such abundant surpluses that then-Fed-head Alan Greenspan fretted there might be no treasury bond market by 2010.

Since 2001, it’s been a rapid glissade down the slippery slope of increasingly radical Keynesian economics. The abandonment of any pretense of fiscal rectitude hit a crescendo during the pandemic. This is when the U.S. stumbled into practicing the dark art of Modern Monetary Theory (MMT), essentially Keynesian policies on performance-enhancing drugs.

Yet, despite dire and reasonable warnings from luminaries of both parties, U.S. federal debt has continued to go parabolic. If you think that is an exaggeration, please check out this chart from J.P. Morgan’s Chief Strategist Michael Cembalest, a rare Wall Street leading light focused on this existential problem.

Chart: Cembalest

As you can see, the slope of the growth in per capita Federal debt, inflation-adjusted, looks like that of a meme stock back in 2021. It’s particularly disturbing when viewed on a per-worker basis, a reasonable tweak since those are the folks who pay most of the taxes to service Uncle Sam’s IOUs.

Unfortunately, forecasts for the future look even worse. Perhaps these might be as off-target as were Alan Greenspan’s back in 2000. However, with the Baby Boomer entitlement tsunami cresting to epic proportions this decade, that’s unlikely.

Chart: Hartnett

Chart: Hartnett

Optimists may understandably embrace my Japanese example by pointing out Japan’s government debt-to-GDP is much higher than America’s. For many years, it has been able to prove the worrywarts wrong and continue wracking up mammoth deficits while enjoying a non-existent cost of capital. However, as we’ve seen, that too-good-to-be-true era may be facing its own reckoning. The brilliant, bowtie-bedecked Jim Grant is on record that potential chaos in the Japanese government bond (JGB) market is one of the biggest financial risks the world presently faces.

Putting that aside for now, a notable difference between Japan and the U.S. is that the former is indebted almost exclusively to its own citizens and corporations. On the other hand, the U.S. is heavily reliant upon international investors, primarily overseas central banks, to fund its trillion-dollar-plus annual borrowings. The other related contrast is the diametrically opposed condition of overall foreign assets and liabilities. As you can see below, Japan is richly endowed with overseas assets, net of liabilities, while the U.S. is the planet’s biggest net debtor.

Jim Grant recently penned a pithy piece called Ponzi on the Potomac. As the title implies, it assails the U.S. government’s utter disregard for spending restraint. He points out that when S&P downgraded the U.S. from AAA status in 2011, our national debt was around $15 trillion. Today, it’s more than double that, about $31 trillion. One has to wonder what S&P’s government debt analysts are up to these days. Perhaps they, like the financial markets, just assume this national balance-sheet-trashing exercise can go on for years to come. In other words, there’s no reckoning anywhere in sight. To my mind, though, the risks of a debt crisis are growing on a daily basis.

Because this is a subject that could fill an encyclopedia (remember those?), I’m going to resort to my old tactic of using a bullet-point summary to concisely convey a lot of key data. (Much of these are from Jim Grant’s “Ponzi on the Potomac” and I will identify them accordingly.)

• The US ran an 11% of GDP budget deficit in 2021 despite booming tax revenues. That’s totally unprecedented in peacetime. It also was the so-called primary deficit, excluding interest. With interest included, it’s worse — and becoming more so with rates up dramatically.

• The government’s own General Accounting Office (GAO) is projecting interest costs to explode to 9% of GDP by 2050. Over the prior 50 years, they’ve averaged 2% of GDP.

• Federal trust funds such as Social Security, Medicare Hospital Insurance and highway construction are all forecasted to be depleted over the next 12 years.

• There is $9 to $10 trillion of Treasury debt maturing in the next two years.

• The Federal government is increasingly borrowing to pay the interest on its debt, a classic Ponzi condition, per the work of the posthumously venerated economist Hyman Minsky.
  

(All of the above are attributed to “Ponzi on the Potomac”.)

• To little fanfare, the U.S. Treasury increased its fourth quarter borrowing by 37%. It also projected $1.3 trillion of financing for the first half of 2023, or an annualized rate of $2.6 trillion.

• In recessions, government deficits blowout due to falling tax revenues and increased social spending (unemployment benefits, etc). Tax receipts are already contracting.

• The typical debt-to-GDP increase in recessions has been 2.8% since WWII. If this downturn is garden-variety, that would amount to around $700 billion of additional deficit spending. (Due to how much entitlement spending has swelled in recent years, that may be way too low.)

• Steepening yield curves consistently foreshadow the starts of recession, following inversions, of course. Presently, the U.S. Treasury yield curve remains highly inverted; i.e., the recession is likely still up ahead.

Chart: Hartnett

• The Biden administration is proposing another $1.7 trillion spending package. This will be spread out over several years, but it is on top of already crushing debt funding needs.

• Estimates of unfunded entitlements exceed $100 trillion, fortunately spread over many years.  However, a growing number of those now need to be paid.

• While the stock market is enthusiastically embracing into the soft-landing thesis, reducing the risks of a recession-induced federal financing crisis, shipping giant UPS just reported its first revenue drop since 2009. FedEx is laying off over 10% of its global management staff.

• The Conference Board’s Index of Leading Indicators have never slid this precipitously over a six-month period without a recession underway or looming soon.

• The International Monetary Fund (IMF) is projecting a rise of 1.7% in the U.S. jobless rate to 5.2%. Yet, it, too, is in the soft-landing camp even though an increase of 0.6% in unemployment has consistently triggered past recessions.

• From 2002 to 2014, foreign central banks bought roughly 50% of U.S. treasury debt. Since 2014, there has been a zero dropped off — their purchases are down to a mere 5%.

Okay, enough with the factoid fusillade. But I’d suggest you take the time to review at least some of them since this issue has such profound implications. The stock markets’ Elvis-like gyrations can distract us all from this escalating threat. And, for sure, a recession is hugely important to stock returns, or the lack thereof, this year. The typical decline in just a garden-variety downturn is 30%, meaning we are less than halfway there. Further, this one has the potential to be worse, given the magnitude of Bubble 3.0. History is clear that the bigger the boom, the bigger the bust.

Yet, even more critical than a year or two hit to S&P 500 profits and stock portfolios is what a recession portends for the U.S. government’s ability to affordably fund itself. Admittedly, the financial markets have bought into the soft-landing scenario of late. Yet, they did that in 2007, too, and that was a big “oops”.

Past recessions have actually made it cheaper for the government to raise money due to falling interest rates. This has often offset the increased cost of more debt outstanding as tax receipts plunge and support payments surge. If that pattern repeats, then there shouldn’t be a problem, at least this year. But here’s where I’m going out on my usual fragile limb: I think this time really could be different, even though I realize those are dangerous words in the financial world.

The added trillions that will need to be freshly financed, along with the above-referenced rollover of 2023’s portion of the $9 to $10 trillion of maturing existing debt, has the very real potential to swamp the market. If Japan, a massive holder of U.S. treasuries, begins selling to bring money home to shore up its own at-risk bond market, that will only compound the problem. The fact that U.S. government entities like the Social Security Trust Fund have become sellers lately, too, further aggravates the situation. Of course, there’s also Quantitative Tightening, which has turned the biggest buyer of U.S. “govies”, the Fed, into the biggest seller. That’s a swing factor of about $2 trillion per year alone.

Any way you slice it, there are many more trillions that need to be bought by the private sector in 2023 than was the case in recent years.  Yet, the powers-that-be in D.C. seem utterly oblivious to this reality, with the stock market just as clueless.

The $1.7 trillion spending bill, all 4000 pages of it, that breezed through Congress in December to be signed by President Biden, is proof positive of this magical thinking (if there is any thinking). Such legislation assumes there are unlimited resources available to our spend-happy elected officials. How many of them actually read those 4000 pages could no doubt rival the number of angels on the proverbial pinhead. Incredibly, it passed with no hearing and no debate. (Perhaps that’s why numerous government agencies will now receive taxpayer-funded drivers.)

As with Japan, because this fiscal degradation has been going on for so long it’s easy to dismiss it and assume all will work out just fine. But that attitude is a huge part of the problem. It enables our politicians to continue pumping out stupendous spending bills with no thought for how they’ll be funded, other than to blithely assume the bond market will pliantly go along with the Ponzi scheme.

But don’t take it only from the Haymaker. On January 24^th, Barron’s ran an Op-Ed by the previously quoted Desmond Lachman, a former top official at the IMF. He’s now a senior fellow at the American Enterprise Institute. Here’s one of the critical sections of that article:

“By far the most worrying of the potential debt crises is that in the United States. That is not simply because the U.S. has by far the largest government-debt market. It is also because the U.S. debt market serves as the risk-free rate by which other interest rates are set around the world. A spike in the ten-year U.S. Treasury bond rate would reverberate around the world.”

With Japan looking to be on the brink of its own bond market riot, and conditions in Italy — incredibly, the world’s third largest bond market — also deteriorating, this is a classic case of forewarned is forearmed. Presupposing that global bond investors will continue to provide forbearance to massively over-leveraged governments might prove as costly to your portfolio as assuming policymakers knew what they were doing with the housing bubble, the pandemic and, most recently, inflation. This is no time, good reader, to let your guard down… even if Jim Cramer is, once again, proclaiming the bear market dead and gone.

---

Defcon’s “Debt Clock” Page (You might want to have a potent adult beverage in hand before accessing this link!)

---

---