Friday, 4 January 2013

Clinging To A Convenient Branch

In action films, a familiar scene is the hero, having gone over a precipice, is next seen clinging to a conveniently placed branch just below the ledge. Something similar has occurred with the “Fiscal Cliff”. In the films, however, the hero undoubtedly scrambles back to the top to win the day. Its not so clear that will happen with the Fiscal Cliff. It could just be a matter of prolonging the agony, before gravity exercises its lawful rights.

The deal struck between Obama, and his Democratic supporters, with the Republicans certainly is no long term solution. A few weeks ago, I wrote that Obama should take the opportunity to press for a Grand Deal, that would not only address the question of the Cliff, but would also deal with the more important issue of the Debt Ceiling. He hasn't. In the process he has now given the Republicans a hostage to fortune, and a second bite at the cherry to mix metaphors.

There were reasons the Democrats and some Republicans would favour going over the cliff. Once over, the tax rises would have come in automatically. That means that the Democrats could propose a tax cut for everyone earning under $250,000 a year, whilst moderate Republicans could support that whilst not having breached their commitment not to vote for any tax rises. On the other hand, going over the cliff, could have provided a big hit for US Business and Consumer confidence, itself sending the economy into recession. The only way that could have been avoided was if it was a prelude to some Grand Bargain that provided a long term solution.

That certainly is not what has been cobbled together. Instead, the deal agreed creates the conditions for further uncertainty dragging on for the next two months, when the saga will be played out again. The only advantage for the Democrats is that it will then take place with a new Senate and House, in which the Democrats position will have been strengthened. The Tea Party seem to be experiencing a rapid decline in their fortunes. But, that does not help the economy.

For the next two months the same kind of navel gazing that occurred in the closing months of 2012 will continue, with mounting concern over whether any deal will actually get done, and what it might be if it does. That is no condition for firms to take major decisions on investments, nor consumers to make plans for their own consumption. Just as the US economy was showing signs of recovery, it could be sent back down again.

After all, now that Obama has lost the advantage on arriving at some Grand Bargain, House republicans can simply refuse to do a deal. They can insist that whatever the democrats decide on the Budget, they will not agree to an increase in the Debt Ceiling, which would be needed to pay for it. If that happens, then the kind of large Budget Cuts that the Democrats oppose, and which would crater the US economy, would happen automatically. Already, the Credit Rating Agencies that have come to the conclusion that austerity doesn't work, and that large amounts of debt can only be dealt with via growth, are threatening to once again downgrade the US Credit Rating. The last time that had no effect, but things have changed since then.

As I pointed out recently - The Zombies Are Coming Part 6 – the latest asset class to be a bubble on the verge of bursting is the Bond Bubble. For a variety of reasons including Financial Repression, but also due to the money printing measures of Central Banks, the price of Government Bonds in the US, UK, Germany, and Japan has risen to levels not seen in centuries. At these levels the risk/return ratio points strongly in the direction of a fall. In other words, there is little scope for Bond prices to move higher, and even if they do, the amount of return from it would be small. On the other hand, the scope for those prices to fall significantly is great. No one will want to be second in line to sell, and so the pressure is mounting to reduce Bond holdings. As pointed out above some large Bond Funds are already doing that.

A few days ago, Bill Gross, who heads up the world's largest Bond Fund, PIMCO, when asked where the Bond Vigilantes were, responded by saying that they had been displaced by Central Banks who had bought up most of the new debt issued by Governments. That is true, and few would argue with Gross, who as a former World Poker star, should know when to fold, and when to hold. However, newly issued debt is not the only debt in the market. There are still trillions of dollars of sovereign debt in the global markets that has been issued over the last 30 and more years, that is still circulating in secondary markets. On top of that, there is trillions more Corporate Debt issued by large companies, whose price has been forced up along with safe sovereign debt. If, holders of these Bonds decide to begin selling then its unlikely that even Central Banks could swallow up all of the supply to prop up prices. Certainly they could not do so without printing money on such a scale that it would risk something like a Weimar style hyper inflation.

In fact, almost unnoticed over the last few weeks the consequences of that have been unfolding. Bond Yields have been rising. Yields move in an inverse direction to prices. Yields for both US Treasuries and UK Gilts have risen significantly. The US 10 Year Treasury has risen from below 1.5% to nearly 1.9%, whilst the UK 10 year Gilt has risen from 1.5% to nearly 2.2%. That may not seem like much, but it represents an almost 50% increase in that time! Imagine your monthly mortgage payment rose by 50%. And that is something many will have to consider, because as Bond prices fall, and Yields rise, so that will have a serious knock-on effect on all other interest rates, including those for mortgages.

With large numbers of people already struggling to meet their monthly mortgage payments, a number that is likely to increase, as wages continue to lag behind prices rising at a faster pace, as inflation picks up again, any such increase in interest rates is likely not only to hammer house prices, but could also see the banks begin to cut their losses, and start to repossess, abandoning their current policy of extend and pretend.

That in turn will only exacerbate the situation on the high street. Comet was only the last in a long line of stores to close its doors at the end of last year, but surveys indicate that a further 150 such retail businesses are close to following them. These are just a fraction of the 10% of UK companies – around 160,000 firms – identified as Zombie Companies that are essentially bust.

According to the UK Services PMI data released today, Britain will have gone into an unprecedented triple dip recession in December. The figures suggest that the UK GDP will have shrunk by 0.2% in the Fourth Quarter of 2012. The signs point for that deterioration to continue into 2013.

So, with concern already mounting over economic growth in the UK and Europe affecting their ability to repay their debts, as has happened with Greece and Spain, as austerity crippled their economies, any sign that a deadlock over the US Budget and Debt Ceiling, followed by a downgrading of the US Credit Rating – a downgrading of UK Debt seems inevitable, as Osbourne's incompetence continues – the likelihood this time, is that it will have a significant impact on US Bond Yields. In the end, return of Capital rather than return on Capital, might follow its natural course, sending money out of Bonds, as it has left many other asset classes, and into cash. In other times, it might have gone to property or gold, but in the US the bursting of the property bubble probably rules that out and in the UK, Spain etc. the property bubble is yet to burst – though it will as interest rates rise. Gold too seems to have peaked for now, and is only likely to rise again if there is a sense that inflation is going to rise sharply.

In short, the zombies are still on the march.

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