Fundmastery Blog

Kurt Brouwer May 29th, 2009

I enjoyed this chart from the Atlantic. Here is the Atlantic’s description of it:

Here’s a pie chart that puts into perspective the size of the Fed’s involvement in the financial crisis. The entire circle represents approximately 8 trillion dollars. Yes, $8,000,000,000,000. The blue quadrant represents federal lending including expansion of swap lines to the tune of about $2 trillion. The purple quadrant comprises housing related purchases ($1.45 trillion) and buying $1.8 trillion of commercial paper. You can see a more itemized breakdown here…

Source: The Atlantic

If you click through to either of the links in the quotation above, you can access this graph in a nifty interactive versions that gives more detail on the various Fed programs included in the rescue effort.

This chart only covers about $8 trillion in Fed stimulus activity. I just wrote ‘only $8 trillion’ and it makes sense. What a world we live in.

The $8 trillion covered in this chart does not cover the total amount in question. There are other programs not counted such as the Treasury Asset Purchase Plan (TARP). I have seen reputable estimates for the total Fed involvement in this ‘rescue’ effort of approximately $12 trillion.

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Kurt Brouwer May 29th, 2009

We have not heard much about the bond market vigilantes since the early years of the Clinton presidency. But now, they’re back!

Carville, Clinton and the Vigilantes

If you don’t remember those days of yesteryear, I can give you a short summary. Back in 1993, President Clinton’s first year in office, interest rates on bonds began rising due to fears of incipient inflation. Those fears stemmed from the inflationary spending plans such as nationalized healthcare and other government programs that threatened to increase Federal budget deficits.

One of President Clinton’s advisors, James Carville, famously quipped that in his next existence he wanted to come back as the bond market because it could intimidate everyone. What Carville and President Clinton grasped back then is that there is a limit to the level of deficit spending that can be absorbed without triggering higher inflation.

Unfortunately, that lesson may have to be relearned as this Bloomberg piece indicates [emphasis added]:

Bond Market Vigilantes Confront Obama as Housing Falters (Bloomberg, May 29, 2020, Liz Capo McCormick and Daniel Kruger)

For the first time since another Democrat occupied the White House, investors from Beijing to Zurich are challenging a president’s attempts to revive the economy with record deficit spending. Fifteen years after forcing Bill Clinton to abandon his own stimulus plans, the so-called bond vigilantes are punishing Barack Obama for quadrupling the budget shortfall to $1.85 trillion. By driving up yields on U.S. debt, they are also threatening to derail Federal Reserve Chairman Ben S. Bernanke’s efforts to cut borrowing costs for businesses and consumers.

The 1.5-percentage-point rise in 10-year Treasury yields this year pushed interest rates on 30-year fixed mortgages to above 5 percent for the first time since before Bernanke announced on March 18 that the central bank would start printing money to buy financial assets. Treasuries have lost 5.1 percent in their worst annual start since Merrill Lynch & Co. began its Treasury Master Index in 1977.

“The bond-market vigilantes are up in arms over the outlook for the federal deficit,” said Edward Yardeni, who coined the term in 1984 to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds. He now heads Yardeni Research Inc. in Great Neck, New York. “Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever.”

…Bill Gross, the co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co. and manager of the world’s largest bond fund, said all the cash flooding into the economy means inflation may accelerate to 3 percent to 4 percent in three years. The Fed’s preferred range is 1.7 percent to 2 percent.

“There’s becoming an embedded inflationary premium in the bond market that wasn’t there six months ago,” Gross said yesterday in an interview at a conference in Chicago.

…This time it’s different because the Congressional Budget Office projects Obama’s spending plan will expand the deficit this year to about four times the previous record, and cause a $1.38 trillion shortfall in fiscal 2010. The U.S. will need to raise $3.25 trillion this year to finance its objectives, up from less than $1 trillion in 2008, according to Goldman Sachs Group Inc., one of 16 primary dealers of U.S. government securities that are obligated to bid at Treasury auctions.

This times it’s different and how. As fears of the financial panic recede, investors around the world are re-assessing U.S. Treasury securities and finding that the trend is not favorable. That has begun to hurt the dollar and our creditworthiness as a nation. Bloomberg continues:

…The dollar has also begun to weaken against the majority of the world’s most actively traded currencies on concern about the value of U.S. assets. The dollar touched $1.4135 per euro today, the weakest level this year.

…Ten-year yields climbed from 5.2 percent in October 1993, about a year after Clinton was elected, to just over 8 percent in November 1994. Clinton then adopted policies to reduce the deficit, resulting in sustained economic growth that generated surpluses from his last four budgets and helped push the 10-year yield down to about 4 percent by November 1998.

…The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.

…Chinese Premier Wen Jiabao said in March that China was “worried” about its $767.9 billion investment and was looking for government assurances that the value of its holdings would be protected.

… “We have daily reminders from bond vigilantes like Bill Gross about the prospect of losing our AAA rating,” Federal Reserve Bank of Dallas President Richard Fisher said in Washington yesterday. “This cannot be allowed to happen.” …

Losing our AAA status would be both disruptive and inflationary. I really don’t know what the odds of that happening are, but I agree with Dallas Fed President Fisher that it must not be allowed to happen (for more on Fisher’s thoughts on foreign holders of our bonds and on inflation, see China: Not So Quiet on the Eastern Front).

Given that government deficits are growing, government debt and financing needs will also grow:

The following chart is one we posted a while back and it has also been included on many other blogs. The point it makes is startling and subsequent events have shown that the CBO estimates used in the chart are now the consensus even at the White House.

The government is incurring debt and ‘printing’ new money at a faster rate than we have seen since World War II. One likely result of this will be budget deficits and pressure for higher taxes - income taxes, corporate taxes, gas taxes and sales taxes. Assuming we have higher tax rates, this will have a negative impact, as it always has, on future economic growth.

This chart from the Washington Post illustrates what we have in store when it comes to Federal budget deficits. The right side of the following chart compares the CBO’s projection for future budget deficits with the White House projections. The left side shows the deficits for previous years, many of which seemed very high at the time. Now, they seem pretty modest by comparison.

Source: Washington Post

Government’s financing needs are growing — actually soaring — so interest rates on Treasury bonds are likely to go up over time simply because the Treasury is trying to issue so many bonds. It’s that archaic and outdated supply and demand thing that musty economics books discuss.

From this report on the U.S. Treasury web site, dated April 29, 2020, we find a clear and concise description of what is to come [emphasis added]:

…Yields on the 30-year bond have risen as of late and are probing their highest level since Autumn 2008. With inflationary pressures scant, the rise in long-dated rates largely is a by-product of the Treasury’s outsized funding needs in the period ahead.

Those outsized funding needs reflect the lackluster outlook for economic growth and the expansionary budgets being pursued by Congress and the Administration. Tax receipts are collapsing amid economic malaise. Revenue is down by nearly 14% in the first half of FY09 and April receipts are tracking their weakest level in years. At the same time, public expenditures continue to surge as automatic stabilizers (unemployment compensation, food stamps, etc.) kick in and the government plows resources toward stabilizing financial firms and domestic demand. In sum, fiscal outlays have increased by over 30% on a year over year basis.

Treasury’s net borrowing needs likely will total about $2 trillion this year, a staggering one-seventh of GDP. Given the outlook for the economy, the cost of restoring a smoothly functioning financial system, and the pending entitlement obligations to retiring baby boomers, the fiscal outlook is one of rapidly increasing debt in the years ahead. Given the outlook for the economy, the cost of restoring a smoothly functioning financial system, and the pending entitlement obligations to retiring baby boomers, the fiscal outlook is one of rapidly increasing debt in the years ahead. While unlikely to materially affect real long-term interest rates today, such a fiscal path could force real rates notably higher at some point in the future…

In other words, the current deflationary trend is still holding Treasury interest rates back, but a few years from now, watch out. Also, the report used the term ‘real rates’ which refers to inflation-adjusted rates. The likelihood is that inflation will be making a comeback in the next few years as well.

As investors, we have to deal with the present disinflationary trend, but also be ready to pivot when inflationary trends begin to take hold. The current rise in prices for oil, gold and other commodities may be a harbinger of inflation immediately ahead or these price increases may just be a reaction to the extremely low prices of late last year.

Right now, I believe intermediate term bond funds are extremely attractive with good yields and even some capital gains potential. Bill Gross’s Pimco Total Return (PTTRX) is an example. I’m not a big fan of Treasury bonds now because yields are going up. As Treasury yields go up, the spread between them and corporate bond yields or mortgage-backed bond yields will narrow.

The Balance Between Disinflation and Inflation

I believe portfolios will have to evolve over the course of the next year or two to be responsive to this new environment. Bonds, especially those with longer maturities, have done poorly in past inflations. Treasury Inflation Protected Securities are one solution. Intermediate term bond funds are another solution as are short term bond funds. Equities have historically been decent, although imperfect, inflation hedges. Other opportunities that should benefit from rising inflation would be energy and commodity-related investments.

Inflation is coming in my opinion and it could go above the levels we had gotten used to over the past 10 years or so. However, I still believe we are in the deflationary or disinflationary phase of this cycle and that inflation is going to remain moderate for a while

The wild card in my thinking is the Federal government. If the Federal government (state governments too) continue on this wild spending and borrowing spree, inflation expectations will change.

Soaring budget deficits brought out the bond market vigilantes 15 years ago. If this trend continues, we will see their rough brand of justice again.

Full Disclosure: Kurt Brouwer owns shares in Pimco Total Return Bond Fund (pttrx)

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Kurt Brouwer May 28th, 2009

Couldn’t resist posting this gorgeous photo of a classic 1958 Corvette. Too bad General Motors no longer has the sense of style and adventure and risk-taking embodied in the release of the Corvette line of cars.

Source: Wikipedia Commons / GNU

Here is a quick roundup on the sad tale and likely demise of GM [emphasis added below]. This Bloomberg piece implies that bankruptcy is a done deal and that it’s coming soon:

General Motors Corp., the world’s largest automaker until its 77-year reign ended in 2008, plans to file for bankruptcy protection on June 1 and sell most of its assets to a new company, people familiar with the matter said.

The U.S. Treasury will provide financing while the asset sale is arranged to a company formed by the government, GM said in a regulatory filing. GM’s path will be smoothed by an agreement today with some of its biggest bondholders on terms for an equity stake in the reorganized automaker.

GM, which would follow Chrysler LLC into bankruptcy, plans to build its new business around assets such as the Cadillac and Chevrolet brands. The 100-year-old automaker, battered by tumbling sales, fell short in a bid to cut debt by $44 billion by the U.S.-set June 1 deadline to restructure outside court…

The Chevy brand is doing OK, particularly the Silverado pickup trucks segment. But Cadillac sales are terrible.

U.S. Treasury to own 72.5% of GM

A second Bloomberg piece reports that some bondholders have accepted a slightly-sweetened offer. No doubt they were influenced by the attack on Chrysler’s bondholders by the administration’s car czar, Steven Rattner, and others.

General Motors Corp. and the U.S. Treasury reached an agreement with some of the automaker’s largest bondholders to smooth the way through bankruptcy.

GM, contemplating a sale of its assets to a new company through bankruptcy, would give 10 percent of its equity to the old GM to pay bondholders and other creditors and issue warrants for as much as 15 percent more, the Detroit-based automaker said in a U.S. regulatory filing today.

GM is trying to restructure debt and labor agreements before it files for bankruptcy protection June 1, according to people familiar with the matter. Advisers to the bondholders, representing 20 percent of the $27.2 billion in principal, support the terms of the plan, GM said in the filing. The Treasury is requiring an unspecified percentage of bondholders agree to the terms by 5 p.m. New York time on May 30, GM said.

…Treasury would get 72.5 percent of GM’s equity and 17.5 percent would go to a union health trust under the plan, the automaker said. Bondholders were previously offered a 10 percent stake…

However, other publications report that the bondholders have rejected the GM offer. A bit confusing at this point, but the outcome is pretty clear to me. The majority owner of GM will be the government with the United Auto Workers union at the number two spot.

With the pending bankruptcy or rescue of GM, the U.S. government’s tab for the equity stake will be very high as this post from the Wall Street Journal’s Deal Book blog indicates:

…Consider this extraordinary fact: The U.S. government is likely putting up to $50 billion in new money to back the company’s bankruptcy reorganization, according to people familiar with the plan.

…It’s clear that a large portion of this amount will be secured with the equity of the “new GM.” Why is the government likely to get equity and not, say, debt with interest and a repayment schedule? Because too much debt would apparently make the company unviable. It’s as if the government has devised an SAT exam for GM, and is blatantly funneling the company the answers.

Okay, fine. So what will this equity be worth?

That’s anyone’s guess. By the logic of some of the people who know the company best – its own unionized workforce – the bet is that it won’t be worth much.

Remember that the union just agreed to take a relatively small portion of its health-care trust in GM equity. The rest will be funded via annual payments on preferred stock. In other words, UAW’s view of the future is clear: Cash today over equity value tomorrow…

That raises the final question, which is, should we let GM fail? I don’t mean a government-enforced bankruptcy filing a la Chrysler, I mean just let it go. The immediate response for many would be, what about all those lost jobs? Let’s deal with the question of jobs and just put the cost of saving them into an economic or financial context. What are those jobs worth?

Here’s an analysis from the auto web site AutoSpies.com that quantifies how much we are spending per job:

…If you look at Fortune Magazines Top 500 for 2008 you will find that GM employes 266,000 employees. Certainly that figure is lower in 2009, but if you apply that number and divide it into the conservative projection of $70 Billion invested to get GM through bankruptcy. The figure you get is over $263,000 per job saved at GM. Now that assumes that none of these 266,000 jobless won’t find a job and will be considered unemployable. In reality almost all of these people will find other sources of income either at a competitor or somewhere else in the economy.

Whatever happened to the notion that if one company failed the market would fill in the gaps? You can argue that GM is too big to fail, but logic dictates that the market void will be filled by the survivors and they will benefits from GM’s missteps. Capitalism is self healing so to speak.

So I guess as we get to the bottom of the barrel we have to ask ourselves two questions.

1. Should we pay over a quarter of a million dollars per employee to save a sinking ship?
2. Would these same employees spend a quarter of a million dollars to save my job?

It is all in how you look at it, I say cut our losses and let the system correct itself.

Excellent point and it’s one we made earlier (see Should We Let GM Fail?).

There are already signs that competitors and others are interested in some of GM’s assets. For example, the well-known former racer and automotive entrepreneur Roger Penske has expressed interest in GM’s Saturn line of cars. GM’s Opel line of vehicles has a couple of suitors. And, I’m sure some car company would want some of the other lines such as Chevy Silverado trucks.

So, let’s consider an alternative to Government Motors. How about we let GM go into an expedited bankruptcy without a government bailout and without cramming down the bondholders? We also allow competitors to bid on various GM divisions.

Once the dust settles, if any employee groups are left without work, we just buy them a $250,000 annuity. The result would almost certainly be cheaper for taxpayers and better for employees and the economy.

Update:

I should have thought of this — government-backed loans for car dealers. After all, when you are bailing out banks and car companies and all, what about car dealers? This announcement from the National Automobile Dealers Association should not come as a surprise [emphasis added]:

…After a number of meetings between the National Automobile Dealers Association and the Obama administration in which NADA urged for greater access to floorplan loans, the Small Business Administration announced today it’s launching a pilot program that will—for the first time—provide eligible dealers with government-backed lines of credit to finance their vehicle inventory.

NADA praised the SBA for its efforts to expand its 7(a) loan guarantee program to include wholesale inventory also known as floorplan loans, since many auto dealers are currently struggling to survive without access to credit to purchase vehicles for their lots. The pilot program begins July 1, 2020 and runs through Sept. 30, 2010, at which time SBA will consider extending the program…

I’d be willing to be a fair amount that the program will be extended. After all, once given, Federal largess is hard to take back.

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Kurt Brouwer May 27th, 2009

Can China dump the dollar? Probably not, but Chinese officials are actively cautioning (scolding, remonstrating…) the U.S. on its profligate ways. China has an estimated $2.5 trillion in reserves, much of which are invested in dollar-denominated securities.

In terms of currencies, I believe there are only two others — the Euro and the yen — that China could look to other than the dollar. Why would China have to move to the Euro or the Japanese yen, if it wanted to sell part of its dollar position? Because China’s financial reserves are big enough that the Chinese government has to have its assets denominated in a very large, liquid currency. And, there are not too many of those around other than the U.S. dollar, the Euro and the Japanese yen.

For a variety of historical and cultural reasons, I doubt if the Chinese would seriously entertain putting most of their foreign currency and foreign assets holdings in the Japanese yen, so the currency choice is between the dollar and the Euro.

Source: Wikipedia Commons

As this piece from the Financial Times [emphasis added] indicates, China has not dropped the dollar in favor of the Euro and is still investing heavily in dollar denominated securities:

…China’s official foreign exchange manager is still buying record amounts of US government bonds, in spite of Beijing’s increasingly vocal fear of a dollar collapse, according to officials and analysts.

Senior Chinese officials, including Wen Jiabao, the premier, have repeatedly signalled concern that US policies could lead to a collapse in the dollar and global inflation.

But Chinese and western officials in Beijing said China was caught in a “dollar trap” and has little choice but to keep pouring the bulk of its growing reserves into the US Treasury, which remains the only market big enough and liquid enough to support its huge purchases.

In March alone, China’s direct holdings of US Treasury securities rose $23.7bn to reach a new record of $768bn, according to preliminary US data, allowing China to retain its title as the biggest creditor of the US government…

I believe China will continue to invest in the dollar and in U.S. Treasuries, but that is not a matter for complacency as we saw in the previous post (China: Not So Quiet on the Eastern Front).

The U.S. Treasury is going to issue enormous amounts of Treasury securities to fund our growing budgetary deficits so we need China to continue investing. As a result, U.S. fiscal and monetary policy will be increasingly tied to keeping China happy and that does not bode well for us. It enforces a discipline of sorts, but our policy options are going to be increasingly limited and necessarily reactive, rather than pro-active.

In terms of alternatives for China, there is some evidence that China is stockpiling commodities such as oil and copper as a hedge against inflation and the falling dollar.

Here is a recent post from Brad Setser’s Follow the Money blog (China’s new barbell portfolio: Treasuries and commodities?) in which he discusses China’s dual strategy of buying Treasuries and commodities:

…At the same time, China has sought to ramp up its exposure to commodities. China’s government clearly is adding to its strategic stockpiles — and perhaps encouraging state firms to build up inventory as well. China’s government is encouraging Chinese state firms to invest more abroad, especially in the mining sector. And China’s government is providing financing to cash-strapped commodity exporters (Russia, Kazakhstan, Brazil and no doubt others) to help tide them through a rough patch and, China hopes, to secure future supplies…

Interesting times aren’t they? The U.S. is supposedly a capitalist country, but government debt is growing and our government is moving further and further into the private sectors of the economy (see Federal Deficits & Debt: What’s an investor to do? and GM Means Government Motors). On the other hand, the supposedly communist country of China is exhorting us to be more fiscally responsible.

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Kurt Brouwer May 27th, 2009

As a sign of the times, I thought this was revealing. The head of the Dallas Federal Reserve Bank passes along some stern advice about our fiscal and monetary policies from China.

This snippet is from a lengthy interview the Wall Street Journal did with Richard Fisher the head of the Dallas Federal Reserve Bank. In it, he spells out the fact that Chinese officials are no longer quiet when it comes to U.S. fiscal and monetary policy [emphasis added]:

…He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. “I wasn’t asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about.”

…”Throughout history,” he says, “what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen. That’s when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can’t run away from it.”…

The last point (in bold) is one that we should consider carefully. Politicians love to make unfunded commitments such as agreeing to additional coverage through Medicare or adding to Social Security liabilities or even hiking pension benefits for government workers. What politicians don’t like to do is pay for those promises. Eventually though, all those promised benefits have to be paid off.

The entire interview is worth reading.

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