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Following an extraordinary week where the S&P lost 8% of its market value, S&P has downgraded the debt of the United States government to AA+ from AAA. This move by the one of domestic  ratings agency follows the downgrade by China’s Dagong Global Credit Rating Co. Putin also chimed in with comments alleging the the United States is “leeching on the world economy”, presumably referring to the U.S.’s post-bubble expansionary monetary policy & fiscal policy leading to:

1) the export of inflation to countries which seek to maintain a stable pricing relative to the U.S. Dollar in favor of domestic exporters

2) the accumulation of massive trillion dollar federal government annual deficits which, in theory, can crowd-out private investment by directly competing with the private economy in the long term capital (primarily debt) markets

3) the demand support for excess U.S. currency due to the seemingly waning world reserve currency status

Questions to investors to consider:

• Is being fully un-hedged and completely exposed to the risk of further U.S. Dollar depreciation prudent from a risk perspective?
• With rates on the 10 year treasury having now rallied to 2.5%, is there an opportunity to rotate out of bonds into other classes?

Check out Peter Schiff’s rather frank, but humorous video from April 18, 2011 in the wake of the S&P warning of the U.S. being on negative credit watch:

S&P as always late to the party!

Lest we forget, re-watch the Treasury Secretary Timothy Geithner’s assurance in April 2011 that there is “no risk” that the government could lose it’s triple AAA rating.

Source Links:

Official S&P Release Document

Dagong downgrades U.S. debt, PBOC chairman speaks of diversification and risk mitigation of China’s foreign reserves

Long term chart of U.S. Treasury 10 year yield from Yahoo! Finance

Full Text via Zerohedge.com

Two of the United State’s most famous and well respected investors have expressed serious concerns with the future of the U.S. Dollar and value of investing in U.S. Treasury debt. Without a doubt, this should be headline news for anyone who is counting on Social Security, a pension plan, or a bond fund to finance their retirement.

Significant points (from the Bloomberg article linked below):

• The “unrecorded debt”, or more precisely the estimated total of the unfunded liabilities of the U.S. Federal government, is $75 trillion.
• This total of the future and current debt burden is 500% of GPD, or five times the total value of every final good and service the U.S. economy produces over the course of an entire year!
• Much of the $75 trillion is a result of the current $14.2 trillion national debt and future spending on entitlement programs in excess of future estimated tax revenue for Social Security, Medicare, and Medicaid.
• Warren Buffett stated, “I would recommend against buying long-term fixed-dollar investments”.
• Bill Gross projects, “the U.S. will experience inflation, currency devaluation, and low-to-negative interest rates after accounting for consumer-price gains if it doesn’t reform its entitlement programs.”

Questions to ask yourself as an investor:

• Given that every other American corporate or state government bond sells at a discount to, or has a higher yield than, Treasuries of the same maturity, what does the massive unfunded liability of the Federal government potentially mean for future bond prices across the board?
• Should you rely on investing in instruments which pose the risk of failing to deliver a rate of return in excess of the rise in the cost of living?

Source Link:

Gross Echoes Buffett Saying Treasuries Have ‘Little Value’ on Debt, Dollar

Bill Gross, who leads the world’s largest bond fund, has recently sold all of his U.S. government bond holdings from his investor’s flagship bond fund. This should catch your attention, as it comes on the heels of PIMCO’s decision last year to launch an equity (stock) mutual fund, rather than being purely a bond shop.

Significant points (from the Bloomberg articles linked below):

• Gross is shortening the maturities of the existing debt he owns (a move which signals an intention to reduce interest rate and/or inflation risk). In the second article, Gross clarifies that he does not see a risk to the credit rating of the U.S. government in the short run.
• Some investors believe that we may be witnessing the end of the roughly 30 year bond market, with yields projected to rise (and conversely, bond prices to fall)
• Inflationary pressures has been greatly building up since the middle of 2010, with the onset of Q.E.2, as commodity prices have been on a rip (fueling, among other things, the unrest in the Middle East).
• “U.S. government bonds are not a safe haven,” said Jim Rogers, when referring to the longest term bond (30 year).
• Gross asks, “The legitimate corollary question is: Who will buy Treasuries when the Fed doesn’t?”

Questions to ask yourself as an investor:

• How heavily weighted should your investment assets be in United States government debt?
• Given the massive run up in commodity prices, will bonds sufficiently preserve your purchasing power?
• If the 30 bond bull market has come to an end, what other asset classes will better position you to increase the value of your portfolio in the future?

Source Links:

Pimco’s Bill Gross Dumping Treasuries Leads Managers Calling Rally’s End

Gross Says Treasury Investors ‘Under-Rewarded With Low Yields

As of today, this clip on YouTube has over 4.3m views. It gives you a pretty quick overview on the following topics (which are closely related the two rounds of “Quantitative Easing” by the Federal Reserve):

• Monetization- when the central bank purchases government debt with newly issued currency. In general, this is highly inflationary, and may lead to a decrease in the purchasing power of the U.S. Dollar as the supply of money increases. In the worst case scenario, the credibility of the government as a borrower is questioned by investors, who may become reluctant to lend to the government at favorable rates or at all.
• Deflation -  Though it may run counter to our everyday experience, the specter of deflation was used as the primary argument in favor of Q.E. 2. Deflation is a decrease in total money supply and credit, which usually expresses itself in a decrease in the general price level. Deflation increases the burden of debt, as money is actually gaining value over time.
• Key Point: In keeping rates low for prolonged periods of time, the Federal Reserve provided the fuel (cheap money) which lit the wild-fires of the tech stock bubble in the 1990s and the housing bubble in the 2000s.
• The clip describes the work of the central planners at the Fed as “playing God with the economy”. It is important to watch the Fed’s actions and speeches because of the large impact it can have on the economy and your investment portfolio. Keep an eye out for unintended consequences of policy action, and consider if you should hedge or even position yourself to profit from the impact!

This clip nearly has 2 million YouTube hits. It may seem a bit odd at first, but you can get a very good grasp of what “textbook economics” and a competing school of thought would tell you about what caused our recent financial crisis and recession, and how to find our way out. Check it out!

Mainstream/Keynesian View

• Views economic health primarily in terms of spending (GPD).
• “Animal spirits” of greed and fear drive the business cycle; irrational exuberance as a key psychological clue of an asset price bubble.
• Advocates large scale increases in government spending (labeled “stimulus”), even if it results in large budget deficits, particularly during a time of recession when aggregate spending is low.
• Encourages loose monetary policy through the central bank’s control of the discount rate. Decreasing the discount rate would represent an effort to encourage bank lending/consumer or business borrowing by lowering the cost of doing so.
• Further unconventional monetary policy measures (such as the purchase of government bonds, mortgage backed securities, etc. from the banks) are considered when the discount rate has already been lowered at or near 0%.
• The hope of such stimulus is to increase nominal spending, or to halt a deflationary spiral (when prices fall, causing employers to lay off workers, who then have less money to spend and may even default on their debt obligations, which in turn causes the money supply to shrink, leading to lower prices, and so on.)

The Austrian School of Economics View

• Artificially low interest rates engineered by the central bank during the boom are viewed as the primary cause of the bubble/boom, and help to make sense of the subsequent bust.
• The low cost of money leads to an unsustainable expansion in credit, which finds a home in a particular asset class, such as real estate in early to mid 2000s, causing prices to be  pushed unjustifiably high.
• The rapid increase in prices encourages over-investment/over-production and speculation since the price signals were reflecting inflation of the money supply, rather than profitability.
• Stimulus, whether monetary (from the central bank) or fiscal (from the government), could be viewed as having another drink when you are already hung-over. The analogy demonstrates the Austrian view that the real problem is not the recession (which is the correction), but the bubble/boom (getting drunk the night before).
• When such stimulus leads to bank bailouts, or the actual purchase of risky mortgage backed securities, the problem of bad debt does not go away. All that changes is who is left holding the bag. Furthermore, since governments much often issue debt to finance these purchases (or print new money the case of the central bank), a consequence of bailouts is an even larger pool of bad debt, but this time it is on the government and/or central banks balance sheet.
• The Austrian view would propose that savings and capital investment are the keys for long term growth.
• As opposed to Keynesians, the Austrians would maintain that the government should not intervene in the economy. Some reasons that could be given are: excessive spending and borrowing created the problem in the first place, increasing the level of debt in the economy will only delay the eventual resolution of the problem of bad debts, the market should be allowed to clear and prices to crash to the point where the economy can heal itself.
• Main point: the bubble was the real problem, not the bust (which serves to correct the mistakes made during the bubble). In the words of the video, “the boom plants the seeds for its future destruction”.