We are out of money

At last some straight talk from the President. Obama stated the obvious in a television interview. "We are out of money". This should be alarming. It wasn't. Ho hum. Yawn. No one cares. The stock market is up. But for the world's most powerful nation to be essentially bankrupt, out of money, and needing excessive amounts of new credit just to keep operating is something that all investors should be extremely nervous about. The US, and other indebted nations, won't be able to spend their way out of debt. That's crazy talk. The debts need to be paid off or be defaulted. Personally people have no choice but to spend less, save, or sell assets in order to pay down their debts. Governments have more flexibility because they can issue bonds with the full backing of the tax base. Government bonds are seen as safe havens, enabling deficit spending which politicians can't resist. They need the discipline of the gold standard. However, an interesting development is unfolding. Just as the high risk individual gets squeezed with higher interest rates on the credit card, so are governments.

Foreign investors hold a sizable portion of the US debt. That debt will not likely be paid back in full, or if it is, it will be with worthless dollars. They know this as they continue to watch the US rack up huge deficits and they aren't impressed. That was the risk they took when they bought the bonds. Don't feel sorry for them. But what can they do and what are the next moves? The first most obvious move for them is to stop giving the US any more credit by purchasing US Treasury bonds, or at least buy less of them. This is already happening. That's why the Fed has been forced into a quantitative easing mode. When the principle buyers pull out of the market, interest rates need to rise in order to attract them back. Except rising interest rates will overwhelm a very fragile debt saturated economy. The Fed doesn't want to see an economic meltdown. When no one else is willing to buy the bonds needed to finance government operations, it moves into the bond market to buy them with money that doesn't already exist. The bonds are bought with new money. New debt for the taxpayer to bear. All those bailouts and stimulus that are meant to cure the economy is being paid for by diluting the value of the existing currency.

The second obvious move foreign creditors would do is to start selling their US holdings. The problem with this is that if they do this en masse, it will flood the bond market with an oversupply which will further depreciate the value of the foreign reserves and may possibly trigger an avalanche of selling as everyone will run to the exits at the same time. No one wants to see that happen. Instead, foreign creditors will first want to gradually sell off the more risky longer term bonds in small chunks without any fanfare. Buyers of longer term bonds are in short supply at the moment because few people have faith in the US to make those bonds good upon maturity, so they are asking for higher rates to compensate for the added risk of default and inflation. A rising interest rate scenario will kill any chance of a recovery because this makes servicing the debt more difficult. The cost of loans of all types will rise, most importantly though, mortgages. There is a consensus that the real estate market has to stabilize before any recovery is sustainable. How high will they go before buyers step in? That is the big question. Moderately higher rates are healthy for recovering banks. They make more money. A dramatic spike in rates will kill them.

The Federal Reserve, the well spring of new money, has stated it will be the buyer of last resort. It will fight this upward bias of interest rates with quantitative easing in an effort to keep mortgage rates low and inject liquidity into the economy. Bernanke believes he can control interest rates by soaking up the demand. However the unintended consequence of this intervention is that it undermines the confidence of bond holders even further as inflation fears rise with the money creation. Sometimes less is more. The market will pressure Bernanke to buy the bonds that they are just itching to sell. It's a battle the Fed will lose because the sell side can overwhelm the buy side. Even though the Fed can print as much money as required to buy anything at any price, it is loathe to do this because it will crash the dollar in the process. Yet that is the course they have embarked on. They can potentially wind up owning most of the Treasuries if it continues to pursue this policy. A cycle will be established where the bond market will continually push interest rates higher, forcing the Fed to intervene time and again. This will drive out foreign equity as they sell into the Fed's buying, and the government will not have it's funding source anymore. It will have to tax and spend less. Read less money for personal consumption, social programs, health care, education, pensions, etc..

The public and media are focused on the stock market but the story of real importance is the bond market. The 10 year Treasury is of particular interest right now. The Fed first felt it necessary to intervene in March back when it was at 3%. They drove the rate down temporarily to 2.5%, but it has since climbed back up and has spiked up to 3.65 this week. The bond market is forcing Bernanke's hand. Will the Fed intervene again? Does Bernanke have faith in his printing press to get them out of this mess? He has staked his reputation on it. Or will he recognize the perilous downward spiral of quantitative easing, once it stops becoming a theoretical play thing? If he backs off the easing, long term interest rates will naturally rise, and trigger yet another debt crisis which will be devastating as the defaulting loans cascade and the faith of the people is demoralized. There is no easy way out of this one. The world is not as rich as we think. There is more debt than wealth and the world economy is moving toward a monetary bottleneck. All indebted nations are competing for the same capital and bond auctions will fail to attract enough buyers to meet the growing deficits. Many governments will simply run out of money. At the end of the line there is no one to bail us out. Governments will be forced to cut back on spending, increase tax rates, devalue the currency, or perhaps they will acquire the money by more creative means, such as engineering a stock market collapse to drive money out of stocks and back into the perceived safe haven of bond markets. Politicians will always take the path of least resistance. Expect volatility going forward.