Thursday, August 4, 2011

Did We Kill the Golden Goose?

The American Armageddon was averted earlier this week when Congress and the President reached a deal to raise the debt ceiling and avoid defaulting on its obligations.  Since the deal was reached, many on both sides are fuming about various aspects of the deal.  Presidential candidates are already using it to position themselves to constituency and the world is still turning.  One of the questions that is being brought up in the wake of falling stock markets and general media inquiry, did we kill the golden goose?  Will we lose our AAA bond status?  Are bond purchasers going to be less attracted to our securities?

Chart 1 - Dow Jones Industrial Average (7/29/11-8/4/11)

Chart 1 shows the Wall Street sell off this week.  Is this sell-off because of insecurity about the U.S. government paying its bills based on resistance to raise the debt ceiling?

Chart 2 - Dow Jones Industrial Average (8/3/09-8/3/11)

You can see the market has been climbing quite a bit in the past year.  I suppose our outlook has grown rosier in the past two years, but perhaps it is getting more pessimistic with job numbers at almost negative growth and GDP about the same.  Market bull runs tend to take on a momentum of their own and continue past the point that economic indicators begin hinting at weakness, so perhaps the market is finally succumbing to neutral economic indicators and is beginning to feel alarmed.

Chart 3 - One Month Treasury Note Rates (8/3/09-8/3/11)

Please note the scale on Chart 3, the reason that it looks as variable as it does is only because of how little variability there actually has been in it.  If one view this graph from before the recession began, it looks quite different.

Chart 4 - One Month Treasury Note Rates (8/3/02-8/3/11)

This graph gives a bit more history to the debate.  What I notice is how closely it follows the Federal Funds rate that the Federal Open Market Committee sets.  This makes sense because the main way that the Fed does this is through Treasury Note repurchase agreements with Treasury Department primary dealers.

Chart 5 - Federal Funds Effective Rate (8/3/02-8/3/11)

The grey portion in Chart 5 shows a period of recession.  The Federal Reserve's Federal Open Market Committee meets once every seven weeks (roughly) to decide whether to raise or lower interest rates.  They then set a target rate, and it is up to the traders at the Fed Board and regional Reserve Banks to meet that target.  It's easy to be oblivious to the ways in which the government intervenes in our markets.  But these last two graphs show pretty well why the U.S. Treasury bond market wouldn't and perhaps couldn't react to any insecurity over a potential U.S. default.

Chart 6 - 100 Oz Gold in Dollars (5/3/11-8/3/11)

This chart shows the price of 100 ounces of gold over the past three months.  I use this chart to show the decline of the Dollar.  One could argue that there is a significant speculative market in gold, but I would counter that this speculation is actually a short on the major world currencies.  Surely these speculators are not guessing that the demand for gold jewelry has risen 10% over the past month!

Ordinarily, when someone is trying to show weakness in the Dollar, they would compare it to another world currency such as the British Pound, Japanese Yen, or more recently the Euro.  This would be fine, but the Dollar has been somewhat on par compared to these currencies because most developed economies are in lackluster shape and sovereign debt levels are high for most of these countries.

So have we killed the golden goose?

Many are speculating the Republicans have killed the golden goose by showing that Congress may not have the political will to pay back its debtors.  I think this is attacking the wrong problem.  Even if we had not had this debacle with the debt ceiling, I think it is likely that we would be facing credit rating downgrades.  The reason we will face those downgrades is because our debt to income to ratio has been  quickly rising.  Our prospects of lowering it, or even significantly slowing this rising ratio only came about because of Republican hold-outs last week.  The truth is the the U.S. debt rating has already been lowered by one agency that I know of (大公国际资信评估有限公司, in China).  It is the largest credit rating agency in China (I don't know if that means anything) but I don't know if that has truly affected rates.  Then again I'm not sure that even a Moody's downgrade will affect us after looking at that Federal Funds Rate (Chart 5) compared to Treasury One Month Rates (Chart 4).  It appears that the Fed is willing to do whatever it takes to hold down Treasuries.

All this sort of exposes the United States as becoming a banana republic.  The government spends our money, and then taxes us through the backdoor via inflation.  I've long wondered that with the United States having such a large debt for so long, what it would take to go bankrupt.  It seems to have a bottomless pit to borrow and repay yesterdays loans (read: ponzi scheme).  It seems then that the true way that the U.S. Federal government would ever go bankrupt is by holding a Treasury bond auction that nobody came to.  So perhaps we have killed the golden goose, but not in a way that is at all obvious, yet.

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