Downgrade Too Little, Too Late

Addison Wiggin – August 8, 2011

  • After the downgrade, the deluge… Why S&P’s call is the mother of all lagging indicators
  • The math Tim Geithner denies, but S&P cannot… and what it means for your future
  • Tallying the market damage: Stocks and commodities hit, gold and Treasuries rally
  • Keeping tabs on the eurozone… a funny video apropos for today’s market action… and a reader’s fears of “indentured servitude” for his children…

   After the close on Friday, Standard & Poor’s tried to retain a modicum of its credibility… they downgraded U.S. Treasury debt from the sterling AAA to slightly tarnished AA+.

After S&P’s sovereign-rating chief John Chambers went on record saying he expected a $4 trillion deficit reduction deal out of the debt ceiling debate, there’s little else the firm could do.

Congress delivered only $2.4 trillion in cuts over a 10-year period. The first $1 trillion is effectively nonbinding because the cuts don’t take hold until the next Congress is in session. The second $1.4 trillion will be decided by a committee of the same congressmen who’ve been avoiding making any spending or revenue decisions to date.

We can’t blame S&P for going through with dinging Uncle’s Sam FICO. Heck, AA+ is letting the old man get off easy. It’s likely going to take a lot more than this pinky slap on the wrist to get Congress to put deficits on any priority list higher than their own re-election bids.

   “I’m surprised Standard & Poor’s would play politics,” former presidential candidate Steve Forbes responded on Sunday talk shows, adding to a chorus of folks either in denial or cheerleading… or exuding arrogance.

“Standard & Poor’s track record has been terrible… and its arithmetic is worse,” former director of the National Economic Council (NEC) Larry Summers echoed. “There’s nothing good to say about what they’ve done.” As if the downgrade came in spite of policies put in place by the administration he counseled.

“If there were a quadruple-A rating, I’d give the U.S. that,” said Warren Buffett, playing the Pollyanna and talking his book (as usual). Although he didn’t really have to; Buffett owns a fair-sized chunk of Moody’s… which maintains a AAA rating for U.S. Treasury debt. [Breaking News: S&P just cut its outlook on Berkshire Hathaway’s AA+ debt from stable to negative. You can’t make this stuff up.]

   S&P has shown “a stunning lack of knowledge about basic U.S. fiscal budget math,” Treasury Secretary Tim Geithner said, mounting a counterattack over the weekend. “And I think they drew exactly the wrong conclusion from this budget agreement” reached last week.

Back in April, two days after S&P warned they were considering a downgrade, Geithner was asked what he thought of S&P’s chances of going through with it.

“No risk of that, no risk,” was his reply.

Surprise.

   Let’s take a look. Here’s the reality about the debt-ceiling deal that S&P seems to be concerned with… perhaps we’re getting the math wrong too. In any case, we’ll enlist the help of Michael Pento of Euro Pacific Capital: “The debt ceiling agreement virtually assures that over the next decade the U.S. will add an additional $8 trillion in public debt, an increase of nearly 80% in 10 years.

“The back-end-loaded deal will cause the amount of deficit reduction to be just $21 billion in 2012 and $42 billion in 2013.”

If we play with those last two numbers a bit, as David Thomas of Equitas Capital Advisors did in a client letter last spring, we get a federal “budget” that looks something like this:

  • U.S. income: $2,170,000,000,000
  • Federal budget: $3,820,000,000,000
  • New debt: $1,650,000,000,000
  • National debt: $14,271,000,000,000
  • April budget cuts that averted a partial government shutdown:
  • $38,500,000,000 (about 1% of the budget)

“It helps to think about these numbers,” Mr. Thomas wrote then, “in terms that we can relate to. Let’s remove eight zeros from these numbers and pretend this is the household budget for the fictitious Jones family.”

  • Total annual income for the Jones family: $21,700
  • Amount of money the Jones family spent: $38,200
  • Amount of new debt added to the credit card: $16,500
  • Outstanding balance on the credit card: $142,710
  • Amount cut from the budget: $385

   “In effect,” Mr. Thomas tried in vain to convey, “Congress, or in this example the Jones family, sat down at the kitchen table and agreed to cut $385 from its annual budget.

“What family would cut $385 of spending in order to solve $16,500 in deficit spending?”

We know our answer: The same family that would agree to cut $210 from its annual budget next year… and $420 the year after that.

At some point, the issuers of the Jones’ credit cards figure out the Jones family won’t be able to keep up minimum payments. When that point is reached, the Jones’ ability to continue running up their debts comes to an end… because the issuers refuse to add to their credit limit.

   “China, the largest creditor of the world’s sole superpower,” read the second statement from the Xinhua news agency on the subject in a week… and not a moment too soon, “has every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets…”

“The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”

That persnickety attitude is going to be trouble for the likes of Bernanke, Geithner and Summers. Even the former Fed chief Alan Greenspan.

   For his part, when David Gregory, moderator of Meet the Press, asked Alan Greenspan if U.S. Treasury bonds still safe to invest in, Greenspan responded with an answer that would drive aficionados of his 1966 “Gold and Economic Freedom” essay batty.

“Very much so,” the former Fed chair assured Gregory, “This is not an issue of credit rating; the United States can pay any debt it has because we can always print money to do that. So, there is zero probability of default.”

Of course, the Chinese are keenly aware of the “quick print” button oft referred to by Greenspan and his successor at the Fed. The Chinese are not concerned about whether Uncle Sam will stiff the Chinese on their interest or principal. They are, however, deeply concerned about whether Uncle Sam will print so many dollars as to make the returned interest and principal worthless.

“China will be forced to consider other investments for its reserves,” says Li Jie from Central University of Finance and Economics. “U.S. Treasuries aren’t as safe anymore. There is a class of assets out there that are more risky than AAA, but less risky than AA+. China didn’t consider these investments before, but now it would be forced to do so.”

And therein lies the rub. S&P may have issued a shot across the bow, however limply. But ultimately, it’s the U.S.’ largest creditors who will be calling the shots. The result could have a drastic impact on your way of life. The symptoms of such a crisis are already appearing around the country… we connect the rest of the dots, here.

   Of course, in the perverse logic of the “safety trade,” both U.S. Treasury debt and the U.S. dollar are rallying this morning. We suspected as much on Friday.

Our reason: When the lemon drops hit the fan in September 2008, the 10-year yields went negative for four days, investors preferring to lose a little money holding U.S. debt than a lot of money in a panicky stock market.

Likewise, the dollar index rallied by 22% as “investors” piled into money market funds.

   Treasuries have, in fact, rallied ever since S&P issued its downgrade warning on April 18. Prices go up as yields come down… and the yield on the 10-year note has dropped from 3.37% the day of the warning to this morning’s 2.47%.

For its part, the dollar index is up to 74.8 this morning — smack in the middle of the range it’s traded in since April.

   In the short term, the downgrade is giving the stock market a rash. The major stock indexes were already getting pummeled on the open today.

Then, S&P downgraded Fannie Mae and Freddie Mac after the market opened this morning.

And why not, if Uncle Sam is putting an implicit guarantee behind them, and Uncle Sam is downgraded from AAA to AA+, it’s hard not follow suit with Fannie and Freddie.

With that, a 2% drop in the major indexes on today’s open became a 3% drop. At 1,155 the S&P 500 is now a mere 105 points away from the lows it reached nearly a year ago, when Federal Reserve chief Ben Bernanke signaled QE2 and sent stocks on a tear.

   Hmmn… the Federal Open Market Committee (FOMC) meets tomorrow. Good times. Stay tuned…

[Breaking News: Make that a 4.5% drop for the Dow and nearly 6% for the S&P. The plunge accelerated as the president delivered a speech, insisting “we’ve always been and always will be a AAA country.”]

   The volatility index, which crested 37 for a while on Friday, crested 38 today.

[Update: Make that 44. Hard to keep up.]

   Commodities are also getting hit hard. The CRB index is down to 322 — the lowest in eight months.

At $83 a barrel, oil is down to a level last seen around Thanksgiving 2010. And at $4.09 a pound, copper has given up all the gains it’s made in the last five weeks.

   “Standard & Poor’s isn’t going to downgrade gold,” writes Byron King.

As we also suspected Friday, gold is proving a beneficiary of the safety trade, alongside Treasuries and the dollar.

From a close of $1,664 on Friday, the spot price powered past $1,700 in overnight trading, settling back as we write to $1,694. Silver is recovering from some of the beating it took late last week — up nearly 2.5%, to $39.25.

“Let’s back up, ” Byron urges. “During boom times, it’s not that difficult to know what things are worth. They’re worth ‘more’ tomorrow than today. That’s a comforting feeling — the ability to go to bed at night and not worry (too much) that the rug will get pulled out from under you while you sleep.”

“But in a recession? How can you ever feel secure about the value of things? What’s a share of General Motors worth? Or IBM? Or Exxon? Or your house? (Heck, what about your job?) Let alone, for investors, what’s the right price for a small, developing company? By day, during a recession, you can watch the news feed and bear witness to the shrinkage of your portfolio. And at night? What ARE those Asian markets doing?”

“Still, if you own gold, one glance at the chart tells you exactly, and to the penny, what you own. There are no hidden agendas. You’re not trying to decipher somebody else’s maze of information about discounted cash flow and net present value. Gold is straight-up protection.”

“Gold is the real money,” Byron continues, rubbing it in. “If I have to explain it, you’re not part of the resistance.”

   We can’t forget what’s happening in the eurozone. The European Central Bank (ECB) is following through on its promise Friday to start buying Italian and Spanish government debt.

“The ECB can’t afford a collapse of confidence,” says Strategic Currency Trader’s Abe Cofnas, “and will buy bonds at levels that are unprecedented — reported at 100 billion euros at a time. It could improve sentiment across the eurozone, pushing its markets higher.”

Still, that’s just a short-term fix. Longer term, Italy and Spain will be hitting up the bond market for $1.2 trillion over the next 18 months.

That’s far more than Greece, Portugal and Ireland combined. And for now, Germany is refusing to kick in more money for Europe’s bailout fund.

   Twice in the last three days, we’ve run across the following video. There’s no day like today to share it with you. You should probably click on it right now before the company whose commercial is being parodied insists on having it taken down:

   “Ah yes, the incredible sacrificial $2 trillion in spending cuts over the next 10 years, but give me the borrowed money upfront trick,” writes a reader of last week’s budget agreement. “One must be a fool to think that future administrations will not find a way to minimize or cancel out cuts in the future. They will be forced to.”

“But with the national debt now heading for almost $17 trillion (which would be more than our annual GDP), if interest rates on that debt rise by 1%, then $170 billion in cuts annually vanish. Just imagine a 2% or greater rise in rates.

“It certainly feels criminal that our government has spent every dime of tax dollars they have ever confiscated plus an additional $14.5 trillion (increasing daily) of future tax confiscations not yet received. It should be unconstitutional to force unborn U.S. citizens into indentured servitude the very day they are born to repay a debt they didn’t create.”

The 5: “I wish it were possible to obtain a single amendment to our Constitution,” wrote Thomas Jefferson in 1798. “I would be willing to depend on that alone for the reduction of the administration of our government; I mean an additional article taking from the Federal Government the power of borrowing.”

Well, it never came about. Hamilton won the day with his argument about the national debt being a “national blessing.” Now the debt is so huge it can never be paid off, except by rendering the currency worthless.

If you don’t want your children to live a life of “indentured servitude,” you need to move to protect the wealth you still have — immediately. We have a few suggestions right here.

Regards,

Addison Wiggin
Agora Financial’s 5 Min. Forecast

P.S. One of our snarky editors reacted to the news about S&P’s downgrade with a yawn. He could care less. He’s not afraid to let you know about it either. He’ll be the first to tell you the S&P and the debt debate are irrelevant to whether he can help you make money. So far this year, he may be right. He’s delivered his readers an average 39% gain.

Think it’s luck… or maybe there’s more to it? We’ll let you decide, right here.

rspertzel

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