Are You Ready for the Aftershock?

US financial woes mean ‘all weather’ fund is needed

Originally published in the January 2010 issue

The recent stock market run-up and the proclamations of many cheerful analysts is leading many to believe that the US economy is on the mend. Unemployment may not have begun falling yet and the US government is still up to its eyeballs in debt, but the faltering economy, so the argument goes, has turned the corner and the recession is all but dead.

Before we bury the coffin of what has been the worst economic downturn since the Great Depression, shouldn’t we pause to take a pulse? Did we really slay this monster or is it just gathering strength to strike again?

One of the key flaws in many discussions about whether or not the recession is over is a basic misunderstanding of what actually happened. To hear some people tell it, you might think a giant recession meteor randomly fell from the sky, blowing an unexpected hole in our otherwise thriving economy. In fact, we’ve been busy for the last three decades creating all the conditions necessary for the recession we have today. This isn’t something that just happened to us; we brought it on ourselves.

To see this requires a fact-based, rational and correct macroeconomic view that most people are missing – not just any macroeconomic view, but the right one. Thinking you have the correct macro view because you know that some subprime mortgage defaults kicked off a domino financial crisis around the world and now that mess is mostly over, is not quite as macro (or as correct) as you may think. There is actually a much bigger Big Picture here.

As we first pointed out in our book, America’s Bubble Economy (Wiley, 2006), the seemingly prosperous US economy is being held up by five co-linked economic bubbles that, while on the rise, help lift the economy in a virtuous upward spiral, and now on their way down, put the US economy at increasing risk in a vicious downward spiral. These economy-booming turned economy-busting bubbles include the:

• Real estate bubble
• Stock market bubble
• Private debt bubble
• Dollar bubble
• Government debt bubble

As we forecast in 2006, back when home prices were still holding up and the Dow was on its way to an all-time high of 14,164 in October 2007, the first three bubbles have begun to fall. The housing bubble popped, the private debt bubble crashed and stocks took a beating.

Now what? We’d love to say the worst is over, but in fact, the same accurate macroeconomic view that led us to the right predictions in our first book and our latest book Aftershock (Wiley, 2009) shows us there is more to come as the dollar and government debt bubbles come under increasing downward pressure.


Pop goes dollar, government debt bubbles
Just as many declare the recession over, the other shoe is poised to drop. What we are about to describe has never happened before and therefore, it may seem hard to believe at first.

Again, an accurate, proven macroeconomic view, based on factual evidence and rational logic, is the only reliable tool for looking ahead—even if we don’t like what we see. Facing facts is always more profitable than denial. Those who wait until it is too late may end up on the losing end of the biggest transfer of wealth in history.

The overriding issue that will determine the timing and severity of the coming aftershock will be the government’s credit limit. The concept of a governmental credit limit is well understood for less-developed economies but rarely discussed in relation to the United States. It’s simply something we’ve never had to worry about before, but that doesn’t mean it doesn’t exist.


What is the government’s credit limit?
America’s credit limit is determined just as every other credit limit: by its lenders. If lenders begin to feel the government is borrowing too much or too irresponsibly, some will become less willing to lend. They will either require higher interest rates or, in some cases, as happened with mortgage-backed securities, they will walk away entirely. So how lenders feel about lending is very important.

The fundamentals of the debt matter, too. Typically, lenders look at a borrower’s ability to pay off debt as a measure of a loan’s riskiness. Often, the statistic used to measure riskiness is a comparison of government debt to GDP, which is extremely misleading. The more useful comparison is our debt to income—the same ratio that banks use to determine loans. The US government gets its income from taxes. Like most entities, America’s income rises and falls with the economy. Our income in FY 2009 was $2.1 trillion. Given that we now owe about $12 trillion, our debt is now about six times greater than our income as shown in Fig.1 (a ratio no bank would ever accept for commercial loans). Needless to say, that’s unsecured debt. By such a measure, our debt is highly toxic. There is simply no realistic way to pay it back based on income, and frankly, the US has shown little interest in doing so. In fact, it has shown great interest in not doing so. As we saw in the mortgage-backed securities debacle, debts that were at once rated AAA can become XXX surprisingly quickly. A combination of lousy fundamentals and falling investor confidence can push a AAA government rating to XXX, at first slowly and then fast, like falling off a cliff. As Mark Twain said about how he went bankrupt: “At first very slowly, and then very suddenly.”

Reaching the US credit limit will be more dependent on lender psychology at that point than fundamentals. How do we know? Because the fundamentals are already pretty bad and investors are still lending us money. What will change investor psychology? Two factors, the first factor is obvious: the US is rapidly increasing its total debt, now at $12 trillion with annual federal deficits projected to increase by at least $1.5 trillion per year for the next four years.

The second factor is less obvious: the US is the largest holder of adjustable rate debt in the world. Not technically, of course, but effectively, because about 36% of its debt has a maturity of less than one year and the average maturity is only 4.3 years (see Fig.2). That means we have to keep refinancing our debt at whatever the current interest rate is. Just like an adjustable rate mortgage, as interest rates rise, our interest payments on the government debt will go up, too. Even if interest rates rise modestly, interest payments on our debt could easily reach $700 billion annually within five years. In is important to note that the 2009 total federal budget was $3.94 trillion. If interest rates rise to levels we saw in the early 1980s, our interest payments could balloon to almost $2 trillion per year—almost equal to our annual income (see Fig.3). Significant increases in our interest payments would seriously erode investors’ confidence, especially for foreign investors, pushing us closer to our credit limit.

Many people say the high interest rates of the early 1980s cannot return. Unfortunately, this is not true. High interest rates are quite possible, and in fact they could go much higher. What could make interest rates go much higher?


The falling dollar bubble
Like all commodities, the value of the dollar is dependent on supply and demand. The ongoing combination of a sluggish economy, a lack-luster stock market for 10 years and fear of inflation could reduce investor confidence and demand for dollars. In addition, the tremendous amount of capital that the US government now demands is putting an enormous supply of new dollar-denominated investments into the market. Rising supply and decreasing demand mean lower prices for the dollar.
Why haven’t these factors already affected the dollar? Actually, it’s already begun. Last spring, modest demand for dollar-denominated debt and massive supply due to a huge increase in the government deficit forced the Federal Reserve to began its quantitative easing program that will soon result in the purchase (with essentially printed money) of almost $1.5 trillion in Fannie, Freddie, and Treasury bonds. To put that in perspective, our money supply, M1, is about $1.6 trillion. That means we have almost doubled our money supply by buying these bonds. It is highly unlikely that we did this simply to keep mortgage rates 1-2% lower. It is far more likely that such a massive intervention was done to avoid interest rates climbing to 8-10%, or even to avoid the possibility of a failed treasury auction.

Needless to say, a failed treasury auction would have highly negative consequences for the value of the dollar.

Because the Federal Reserve intervened and because investors still view the dollar as a safe haven in times of financial crisis, a dollar crisis was averted. Also there has been substantial support for the dollar from key central banks around the world. However, we have only kicked the can down the road. We haven’t solved the underlying problems of piling massive new debt on top of truly massive existing debt, or finding buyers for all this new debt, or rolling over the old debt. Instead, the Fed has postponed dealing with these issues and has created an even bigger problem by becoming what we call the “Frito Lay Fed.” Like the Doritos commercial that says “Eat all you want; we’ll make more,” the Fed is essentially saying to Congress, “Spend all you want; we’ll print more.”
In time, massively increasing our money supply will create serious inflation, especially if, instead of reversing the purchases of bonds, the government is forced to continue such practices, as we predict they will, given the massive deficits the US will likely face due to reduced tax revenues and increased spending. Such inflation will take time to enter the system, but enter it will.

Rising inflation will cause rising interest rates, which will increase the government’s interest payments on the debt, as discussed earlier. Higher interest rates will also significantly hurt the economy, with negative impacts on commercial and residential real estate, business growth, employment, and the stock market. All this will further erode investors’ confidence, and the vicious downward spiral of America’s falling bubble economy will accelerate. Eventually, investor confidence will become investor fear, the government’s credit limit will be reached, and the party will be over.

Can it really happen now?
One thing we hopefully learned from the real estate bubble is that new circumstances can change long-standing historical trends. Before the 2008 housing crisis, nationwide US home prices had never fallen significantly or for any length of time. However, home prices had also never risen nearly 100% in approximately five years, while incomes rose only 3%. Unusual circumstances do create unusual (althoughquite logical) consequences.

The same is true for the dollar and US debt. Both now face unusual conditions; therefore we must expect usual future consequences. Expecting historical trends to continue when circumstances have significantly changed is illogical. Right now, we have not one, but many unusual conditions, including high federal debt, high dependency on foreign investors to fund our debt, slow economic growth, rising unemployment, and a falling housing bubble, stock bubble, commercial real estate bubble, private debt bubble, consumer spending bubble, and many related smaller bubbles.

The combination of all these unusual conditions in the United States is unprecedented. Hence, something unprecedented will occur.

When will the aftershock hit?
At some point, inflation and interest rates will rise enough, investor confidence will wane enough, and the dollar will fall far enough that our debt auctions will begin to fail and we won’t be able to borrow the money. We will have hit our credit limit and the massive government debt bubble will pop.

How much can we borrow before this happens? At the end of 2008 in a presentation we made to the World Bank, we asked the audience what they thought the government’s credit limit might be: $10-15 trillion, $15-20 trillion or $20-$25 trillion. Almost half said $15-$20 trillion, and a third voted for $20-25 trillion.

The government’s actual credit limit depends on future investor psychology, which no one can predict with precision. However, we agree with our World Bank audience that our credit limit will be in the $15-$25 trillion range, most likely closer to $25 trillion. If that’s true and if interest rates don’t rise much, we won’t hit our credit limit for many years. However, if our analysis is right and interest rates do increase significantly, we will slowly move toward our credit limit over the next two to three years, then rapidly approach our credit limit within three to five years. At that point, the dollar and government debt bubbles will fully fall.

Are you ready for the aftershock?
While a considerable amount of wealth here and around the globe will evaporate, the coming aftershock will offer many opportunities for asset protection and big profits. Opportunities clearly include properly timed shorting of long term debt and stocks, both domestically and internationally, as well as currency trades that take advantage of rising international currencies.

Remember the lessons of last year’s crash: no matter how sophisticated or previously profitable your investment strategies, they are only as good as the macroeconomic outlook upon which they are based. Wrong input assumptions about the larger trends can kill the most ingenious quant modeling outputs. So the correct macro view is absolutely essential.
You also need the correct quantitative analysis to see how your current investment strategies will fare in the unusual macroeconomic environment ahead. Any other kind of risk analysis is, frankly, just too risky.

In a related note to hedge fund managers, the current interest in gold among some mangers is well-founded. In fact, we see gold ultimately moving quite high and becoming an expanding bubble as the US government begins to falter on interest payments on its debt.

The exact timing and longevity of the future gold bubble is complex, but it will likely be highly profitable for those who play this macroeconomic trade properly. Think of it like a well-placed bet against mortgage-backed securities before the 2008 crash, only much more profitable.

Robert Wiedemer, David Wiedemer and Cindy Spitzer are co-authors of America’s Bubble Economy, and Aftershock, both published by John Wiley & Sons in October 2006 and November 2009 respectively. Robert Wiedemer is president and CEO of The Foresight Group, a macroeconomic forecasting and risk assessment firm located in the Washington, DC area. David Wiedemer is chief economist at The Foresight Group, heading up the firm’s macro research efforts.