February 27, 2013

When Push Comes to Shove, Central Banks Print

Posted in Inflation, National Deblt, Uncategorized tagged , , at 4:52 PM by Robert Barone

Inflation is always and everywhere a monetary phenomenon– Milton Friedman

With worldwide demand for oil ebbing [.5% growth in ’11 and .3% since ’08 (compound annual growth rate – CAGR)], and with huge new discoveries, it would be logical that the price of related commodities would be falling. The price of gasoline, for example, is currently 2.3 times its $1.61/gallon low of four years ago. The price of gold, while down from its peak, is still much higher than its $1,100/oz price at that time.

The question: Why have the prices of these hard assets risen so rapidly despite high unemployment, weak demand, and excess capacity in the economy? To answer this question, one must understand the underlying structural issues facing the U.S. and the developed world, and the responses to these issues from governments and central banks.

Structural Budget Issues

The National Debt of the U.S. currently stands at $16.5 trillion, and unless current economic growth improves dramatically, and soon, the actual National Debt is likely to be closer to $22 trillion by 2017.

 

 

(millions $)

USDebtClock.org

2013 Spending Estimate

% of 2013 Federal Spending

 

2017 Spending Estimate

 

2017

Source

% of 2017 Federal Spending

Medicare/Medicaid

$808,743

22.8%

$1,058,498

CBO

25.8%

Social Security

$773,149

21.8%

$959,742

CBO

23.4%

Defense

$667,670

18.9%

$618,839

CBO

15.1%

Income Security

$353,387

10.0%

$353,387

No change

8.6%

Interest on Debt

$223,123

6.3%

$333,912

CBO

8.2%

Federal Pensions

$213,084

6.0%

$266,065

At current rate

6.5%

   Total

$3,039,156

85.9%

$3,590,443

 

87.7%

Tax Collections

$2,480,788

70.1%

$3,612,352

CBO

88.2%

The table shows estimates of spending for the six largest federal expense categories using USDebtclock.org 2013 estimates and CBO estimates for 2017. The issue is that these six categories eat up 100% of total tax collections even under CBO’s optimistic set of assumptions. On top of these six categories is the cost of the other functions of government including all of the internal departments (DOJ, Homeland Security, EPA, Commerce, Interior, State, etc.) and the off budget expenses of the agencies (FNMA, FHA, GNMA, FHLMC, Post-Office, Amtrak, etc.).

The Debt Cost Issue

In Japan, the Debt/GDP ratio is more than 200%, and the interest cost of the debt is 20% of tax collections. The coupon cost of the debt is about 1%. If rates rose to 3%, 4%, or 5%, the cost of their debt would rise to 60%, 80%, or 100% of their tax collections. Clearly, they could not allow this to happen, and either default or massive inflation would occur. Interestingly, Japan has embarked on a massive money printing scheme and has compromised the independence of its central bank in the process.

Using the maturity structure of the existing U.S. Treasury marketable debt, the table below shows estimates of what would happen to the cost of the debt in five years under different rising interest rate scenarios. A return to a “normal” interest rate structure may truly be a budget busting event.

 

Yield Curve Rises By

Change in Cost (bill $) if Debt is $22 Trillion Total Interest Cost (bill $) (CBO + Change Due to Yield Curve Shift) Total Interest Cost as a % of CBO Estimated 2017 Tax Collections

200 bps

$299

$633

17.5%

300 bps

$433

$767

21.2%

500 bps

$699

$1,033

28.6%

700 bps

$966

$1,300

36.0%

The Real Budget Deficit Issue

On January 17, the U.S. Treasury announced that the deficit for the 2012 fiscal year, using Generally Accepted Accounting Principles (GAAP) was $6.6 trillion, of which $5.3 trillion was the net present value of the future promises that were made in 2012 alone. This isn’t really a surprise, as the GAAP deficits have been in excess of $5 trillion since the Recession. Unfortunately, the number is simply ignored by the media and the markets. Due to demographics, such annual promises will only increase under the current social programs in the U.S. for the next ten years. The structural deficit is most likely the most critical economic issue of our time.

Scary Scenario

We all hope that the economy picks up, the unemployment rate falls, and that economic growth returns to a more normal pace. But, if that doesn’t soon happen, investors, both foreign and domestic, may begin to lose faith in the dollar as the world’s reserve currency, and, despite an under performing economy, demand higher interest returns. This type of scenario is what played out in Europe in 2011-2012 when rates rose on the debt of Greece, Portugal, Spain and Italy. Note that the European Central Bank rode to the rescue of the European Union periphery by printing tons of money and by purchasing the debt of the above named countries.

Here is the dilemma: If interest rates rise back to normal levels, the cost of the debt becomes a huge issue, especially if the economy is under performing. In the U.S., add to that the inability to control the debt issuance due to the structural problem outlined above. Those issues keep the Deficit/GDP ratio high and start a death spiral of ever rising rates which chokes the economy. And, as we saw in Europe last fall, the only relief that will satisfy the capital markets (i.e., the “bond vigilantes“) is a massive money creation.

For politicians, inflation via money printing is the easiest choice even if it means a subjugation of the independence of the central bank to the government’s will, as we are witnessing in Japan. Gold and other hard assets have, over the last few years, also been influenced. The precedents have clearly been set both in Europe and Japan. When faced with the choice of higher rates or money printing in an under performing economy, it is clear what the choice will be.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

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January 16, 2013

Headwinds Will Keep Interest Rates Low

Posted in Economy, Taxpayer Relief Act, Uncategorized tagged , , , , at 5:46 PM by Robert Barone

On Jan. 2 when President Barack Obama signed the American Taxpayer Relief Act of 2012, there was no pomp and circumstance that has been characteristic of this administration.

That seemed strange given the fact that the president got much of what he wanted in the so-called “fiscal cliff” bill. I expected to see several “middle-class” families at the signing ceremony, applauding the president for saving them from significant tax increases.

But they were strangely absent and with good reason. Like much of what comes out of Washington, the title of the legislation is 180 degrees opposed to what the legislation actually accomplishes, for this was not a taxpayer relief act! After two years of campaigning to tax only the “rich” and protect the middle class, there was no pomp and circumstance because the middle class got the shaft.

$125 billion

 

Income

2012

AGI

2012

1040 Taxes

2012 (4.2%) Payroll Taxes

2012 Total Taxes

2012 Eff

Tax Rate

 

 

$48,000

$40,000

$5,134

$2,016

$7,150

14.90%

   

$60,000

$50,000

$6,634

$2,520

$9,154

15.26%

   

$72,000

$60,000

$8,134

$3,024

$11,158

15.50%

   
               

 

Income

2013

AGI

2013

1040 Taxes

2013 (6.2%) Payroll Taxes

2013 Total Taxes

2013 Eff

Tax Rate

Tax Increase

Tax Pct Change

$48,000

$40,000

$5,134

$2,976

$8,110

16.90%

$960

13.43%

$60,000

$50,000

$6,634

$3,720

$10,354

17.26%

$1,200

13.11%

$72,000

$60,000

$8,134

$4,464

$12,598

17.50%

$1,440

12.91%

The table packaged with this column shows an estimate of the 2012 and 2013 taxes on Americans of modest means (middle class). These are wage earners married, filing jointly and making $48,000, $60,000 and $72,000 with adjusted gross income on their 1040 forms of $40,000, $50,000 and $60,000, respectively.

As you can see, taxes for 2013 have increased by 2 percentage points for the same income and AGI levels for the middle class (see the 2012 and 2013 Effective Tax Rate columns).

The amount of tax increase on a family making $48,000 with an AGI of $40,000 is nearly $1,000. For these middle-class folks, taxes have risen by 13 percent for a total reduction in disposable income of $125 billion, according to Michael Feroli, a JPMorganChase economist. Ouch! Such tax increases are sure to have an impact on consumption and economic growth.

Spending negotiations

While Congress and Obama reached a last-minute deal on taxes, the spending and debt ceiling issues remain unresolved. We can assume with a relatively high level of confidence that in the upcoming round of caustic negotiations, there will be some cuts to spending, even if they are out on the horizon.

But, for sure, immediate spending won’t be going up, and there likely will be cuts to programs for state and local governments. Such spending control, or even a semblance of it, will put downward pressure on economic growth. Generally, when growth is slow (and when the Fed is pushing easy money), interest rates remain low or are falling.

Housing headwind

Investors today are being told to stay away from fixed-income investments because interest rates are sure to rise. Given that rates are at historic lows, that statement undoubtedly is true. The question is, “When will they rise?”

Recognize that, besides the issues I have outlined, rising rates will create yet another headwind in the housing finance market.

Mark Hanson is a mortgage market specialist in the Bay Area. He recently said that “there is absolutely no doubt that the unprecedented 5.25 percent midyear 2011 to 3.5 percent midyear 2012 Fed-induced plunge in mortgage rates had a positive impact on refi volume, consumer cash-flow (emphasis added), home sales …”

Anything, he said, that reduces refi volume will have a large impact on consumer cash-flow. “If rates remain flat at 3.5 percent, refi burnout will take fundings down 33 percent … If 30-year rates hit 4 percent, at least half of all refis … will evaporate literally overnight.” That will significantly impact disposable income growth.

The Fed

During the first week of the year, the minutes of the Dec. 12 Federal Open Market Committee (i.e., Fed minutes) were released showing a dispersion of opinion among the FOMC members:

“Several others thought that it would probably be appropriate to slow or stop purchases (of securities for the Fed’s portfolio) well before the end of 2013 citing concerns about financial stability or the size of the balance sheet.”

The investment community became concerned and as a result, yields on 10-year Treasury securities rose from 1.7 percent to over 1.9 percent, and this has led to the concerns over fixed-income investments expressed above.

David Rosenberg, a noted Wall Street economist, examined all the past FOMC minutes since the economic crisis and found similar language in the FOMC minutes of April 15; April 27, 2011; March 15, 2011; Nov. 3, 2010; and April 28, 2010. Each time the market reacted initially by pushing rates up proved to be a buying opportunity for fixed-income investors.

Conclusion

In the face of a significant rise in taxes for America’s wage earners, downward pressure on government spending and the hit to housing finance that rising rates would bring, it looks doubtful that interest rates can rise significantly anytime soon.

The Dec. 12 minutes didn’t contain any new information; we have seen it all before. So, fixed income investors should take heart; rates don’t look like they can rise significantly from here in the near term..

Taxes on American income levels

This table shows an estimate of the 2012 and 2013 taxes on Americans who are married, filing jointly and making $48,000, $60,000 and $72,000 with adjusted gross income on their 1040 forms of $40,000, $50,000 and $60,000, respectively.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs. Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.