Phisix: US Debt Ceiling Deal and UNTaper Spurs a Global Melt UP

Melt Up!

Melt UP!

Suddenly stock markets metastasize into a frenetic melt-up mode.

In the US, the S&P 500, the S&P 400 Mid-caps and the small cap Russell 2000 set new record highs. 

The German Dax and the French CAC also carved fresh landmark highs. 

In Asia, Australia’s S&P ASX, and India’s Sensex shared a similar feat. Ironically just a few months back the Indian economy seemed as staring into the abyss—to borrow from German Philosopher Friedrich Nietzsche[1]. How confidence changes overnight

And knocking at the door of historic highs are New Zealand Exchange 50 Gross, South Korea’s KOSPI, Taiwan’s TWSE, Hong Kong’s Hang Seng, and Malaysia’s KLSE

Media explains the melt up as a function of the debt ceiling deal and extended US Federal Reserve ‘credit easing’ stimulus. From Bloomberg, “U.S. stocks rose, sending the Standard & Poor’s 500 Index to a record, as speculation grew that the Federal Reserve will maintain the pace of stimulus after Congress ended the budget standoff.”[2]

Thus the common denominator in explaining the melt-up has been the market’s worship of debt expressed via the orgy of the speculative hunt for yields in the asset markets, particularly the stock markets.

Will the global melt-up influence the Phisix, the likely answer is yes. But….

How the FED Alters the Priorities of US Corporations

Goldman Sach's chief US equity strategist, David Kostin has been quoted as attributing the current US stock market surge on P/E multiple expansion, “The S&P 500 has returned 22% YTD driven almost entirely by P/E multiple expansion rather than higher earnings.”[3]

 

This means record US stocks has hardly been about earnings growth but of the aggressive bidding up of the equities.

More signs of the yield chasing frenzy.

In addition, as pointed out above by Blackstone Group’s Byron Wien[4], S&P 500’s net income has been on a decline since 2010. This decline has been accompanied by a slowing of earning per share growth (y-o-y).

Yet, the modest gains in the growth rate of the S&P’s EPS have mainly been bolstered by share buybacks. 

And as previously pointed out[5], a substantial portion of corporate share buybacks has been financed by bonds which remains a present dynamic[6]. 

In other words, the FED’s easy money policies, including the “UNTaper” have been prompting many publicly listed companies to shore up or ‘squeeze’ earnings growth via debt-financed corporate buybacks meant to raise prices of their underlying stocks.

Share buybacks has essentially substituted the capital or investment based expansion or the organic earnings growth paradigm. Said differently, publicly listed corporations have joined the herd in the feverish speculation on stocks rather than investing in the real economy.

This also means that the yield chasing mentality has infected the corporate board rooms, where corporate models appear to have been reconfigured to focus on the immediate attainment of higher share prices. 

And a recent research paper has underscored such changes. Stern School of Business John Asker, Harvard’s Joan Farre-Mensa and Stern School of Business Alexander Ljungqvist finds[7], (bold mine)

Listed firms invest substantially less and are less responsive to changes in investment opportunities compared to matched private firms, even during the recent financial crisis. These differences do not reflect observable economic differences between public and private firms (such as lifecycle differences) and instead appear to be driven by a propensity for public firms to suffer greater agency costs. Evidence showing that investment behavior diverges most strongly in industries in which stock prices are particularly sensitive to current earnings suggests public firms may suffer from managerial myopia.

So short-termism, mainly brought about by the Fed’s policies, has afflicted many of the publicly listed firm’s priorities. Many executive officers and shareowners have presently elected to use the unsustainable speculative financing model of boosting earnings that yields temporal benefits for them.

This essentially defies Ben Graham’s 1^st rule of margin of safety where companies should stick to what they know or ‘know your business’ and to avoid to making ““business profits” out of securities—that is, returns in excess of normal and dividend income” as I showed last week[8].

Yet all these will depend on the persistence of easy money regime, the suppression of the bond vigilantes and the sustainability of debt financed buyback model.

So while most publicly listed US companies have yet to immerse themselves into Ponzi financing, sustained easy money policies have been motivating them towards such direction.

A Dot.com Bubble Déjà vu? Google as Symptom?

The scrapping for yields has impelled many to jump on the IPO bandwagon despite poor track record of newly listed companies. 

According to the Wall Street Journal, 19 out of 28 or 68% of the technology issues which debuted this year has been unprofitable over the last fiscal year or during the past 12 months, which has been the highest percentage since 2007 and 2001. Yet punters wildly piled on them.

The same article notes of intensifying signs of mania “The excitement over companies’ potential rather than their present results is the latest sign in the stock markets of a rising tolerance for risk. The U.S. IPO market, often seen as a gauge of risk appetite because the stocks don’t have a track record, is on pace to produce the most deals since 2007, according to Dealogic”[9]

And Art Cashin UBS Financial Services director of floor operations at a recent CNBC interview expressed worries over a remake of the dotcom bubble, “The way people are treating technology companies, it's starting to feel a bit too much like 1999 and 2000”[10]

1999, 2000 and 2007 signifies as the zenith of the dotcom (1999-2000) bubble and the US housing bubble (2007)

Has Google been leading the way?

Google’s [GOOG] stock breached past the US$ 1,000 levels (particularly $1,011.41) with a breath-taking 13.8% gap up spike last Friday.

At market cap of over $335 billion, Google surpassed Microsoft [MSFT] and is now the third largest company after Apple [APPL] and Exxon Mobile [XOM][11].

Since Google is a member of the S&P 500[12], Friday’s quantum leap materially contributed to the new record of the major S&P bellwether (SPX). 

And as shown in the same chart, the S&P 400 mid cap and the small cap Russell 2000 flew to the firmament last week.

Three of the 5 largest S&P companies are from the information technology. In addition, technology comprises the largest sectoral weighting at 17.7% on the S&P, followed closely by financials 16.5%, and from a distance, Healthcare 13.2%, consumer discretionary 12.3% and the others. 

Should the technology mania persist, this will be reflected on the relative strength of sector, as well as, through a bigger share of the same sector in the S&P 500’s sectoral weighting.

Surprise 3rd quarter revenue growth of 23% from advertising part of which came from the mobile platform and Wall Street “emotion” has been attributed to Google’s spectacular price spike.

This Yahoo article[13] says that part of adrenaline rush on Google’s share prices has been to due low exposure on stocks by institutional investors (bold mine)

Google is higher today because it reported strong numbers, but it's not a 10% better company today than it was 24 hours ago. Wall Street is in a manic phase at the moment. For all the terrific things about Google's third-quarter, the best thing about the report was that it came on a day when institutional investors are feeling like they have far too little exposure to stocks. The average hedge fund was up less than 10% through September and there weren't many people expecting this race to new highs on the S&P500 (^GSPC) on the heels of debt ceiling debacle.

In short, more signs of frantic yield chasing.

Google’s reported 3rd quarter earnings of $10.74 per share[14], which came ahead of consensus estimates of $10.34.

While I am a fan of Google’s products, I hardly see value in Google’s stocks. 

Yahoo data[15] shows that Google has a trailing PE (ttm or trailing twelve months intraday) at 27.52, forward PE (fye or fiscal year end: December 2014) at 19.42, Price/book (mrq or most recent quarter) 3.75 and enterprise multiple of enterprise/ebitda (ttm or trailing twelve months) at 16.14.

The above multiples exhibit how richly priced GOOG has been

The same applies to the general stock market

Based on the prospects of continued declining earnings growth rate and based on the trailing PE[16], as of Friday’s close, the Dow Industrials has a ratio of 17.24, from last year’s 14.47, the S&P 500 at 18.32 from 17.03 a year ago and the Nasdaq 100 at 20.88 from last year’s 15.24. 

Most shockingly, the small cap Russell 2000 has a PE ratio of 86.58 from 32.69 a year ago! The Russell PE ratio more than doubled this year. Wow.

While I have not encountered GOOG resorting to share buybacks yet, GOOG’s increasing recourse to debt to finance[17] her operations has hardly been an attraction.

What perhaps may justify GOOG’s current prices is the prospect of success from its upcoming products such as the driverless cars, Google Glass and the cloud based planning applications called the “Genie” targeted at the construction industry[18].

But this would be audacious speculation.

And overconfidence has become a dominant feature.

Aside from stock market bulls brazenly hectoring and scoffing at the bears, market participants have been conditioned to see stock markets as a one way street.

For instance, record stocks which brought about the biggest single-day decline in U.S. equity volatility since 2011 rewarded the bullish option traders who aggressively doubled down on bets that the bull market in stocks would survive the default deadline[19].

The consensus has been hardwired to see any stock market decline as opportunity to “double down”.

For the bulls, risks have vanished. The stock market’s only designated direction seems up, up and away.

Yet the bullish consensus seems oblivious to the reality of the deepening dependence the stock market (and even housing) has been to the Fed’s credit easing measures. They are ignoring the fact that corporate business models have been evolving towards speculation, rather than to productive investments. Expanding price multiples, declining net income and EPS growth rate, increasing dependence on buybacks and debt financing for speculation are symptoms of such transition.

Aside from corporations, the convictions of bullish market participants are being reinforced by evidences of more aggressive actions.

While I don’t expect the FED to take the proverbial punch bowl away, everything depends on the actions of the bond vigilantes. For now, the bond vigilantes have been in a retreat. The hiatus by the bond vigilantes provides room for the bulls to magnify on their advances. Question is for how long?

If QE 3.0 in September of 2012 pushed backed the bond vigilantes for only 3 months, will the euphoric effects of the UNtaper, Yellen as Fed Chairwoman, debt ceiling deal last longer?

The French Disconnect

As I pointed out above, the UNtaper-debt ceiling deal has incited many markets to a melt-up mode which media rationalizes as “recovery”.

The French stock market, which is also at record highs, serves as an example.

The CAC 40 has been rising since the last quarter of 2011. Yet during 2012-2013, as the CAC rose, the French economy vacillated in and out of negative growth rates or recessions. While economic growth statistics reveal of a recent recovery, sustainability of the recovery is unclear.

French industrial production was down 1.6% in August[20], Unemployment rate is at the highest level since 1998 at 10.9% at the second quarter[21]. August loans to the private sector have been trending downwards since May[22]. Fitch downgraded France last July[23]. [note to the aficionados of credit rating agencies, French downgrade coincided with higher stocks]

Yet the CAC continues to trek to new highs. What gives?

Notes on the Debt Ceiling Deal

Furloughed Federal employees will receive a back pay[24]. This means government shutdown for furloughed employees extrapolates to a paid vacation.

The bi-partisan horse trading resulted to insertions of various goodies (Pork) for politicians. This includes $174,000 death benefit for Sen. Frank Lautenberg’s widow[25]

The US treasury will be authorized to suspend the debt ceiling as I earlier posted[26]. A limitless borrowing window will be extended until February 7, 2014[27].

This marks the second time when the debt ceiling has been unilaterally suspended. The first occurred this year from February 4, 2013 to May 18, 2013[28].

What seems as an increasing frequency of the suspension of the debt ceiling (twice this year) may presage a permanent one.

A day past the US debt ceiling deal, US debt soared by a record $328 billion. This has shattered the previous high of $238 billion set two years ago as the US government reportedly replenished its stock of “extraordinary measures” used to keep debt from going past he mandated level[29]. This brings US debt to $17.075 trillion Thursday.

Two days after, US debt further expanded by $7 billion to $17,082,571,268,248.24[30].

Debt levels growing at a rate far faster than the rate of economic growth is simply unsustainable.

Since 2008, US Federal has grown past $ 7 trillion whereas the economy grew by nearly $1 trillion[31].

There is always a consequence to every action, so will the above.

Yet this is what equity market praises.

---

[1] Friedrich Nietzsche CHAPTER IV: APOPHTHEGMS AND INTERLUDES Beyond Good and Evil, p 107 planetpdf.com

[2] Bloomberg.com S&P 500 Surges to Record on Fed Bets After Debt Deal, October 18, 2013

[3] Zero Hedge Goldman: Entire S&P Move Higher Is Due To Multiple Expansion; Shiller P/E Says 30% Overvalued So... Buy

[4] Business Insider Net Income is Actually Declining even as Earnings Rise, Wall Street's Brightest Minds Reveal THE MOST IMPORTANT CHARTS IN THE WORLD, October 9, 2013

[5] See Phisix: Rising Systemic Debt Erodes the Margin of Safety October 14, 2013

[6] Reuters.com Bond-backed stock buybacks remain in vogue September 6, 2013

[7] John Asker, Joan Farre-Mensa and Alexander Ljungqvist Corporate Investment and Stock Market Listing: A Puzzle? April 22, 2013 Social Science Research Network

[8] See Phisix: Rising Systemic Debt Erodes the Margin of Safety October 14, 2013

[9] The Wall Street Journal Market Pulse In Latest IPOs, Profits Aren’t the Point October 11, 2013

[10] CNBC.com Cashin: Tech valuations remind me of dot-com bubble October 17, 2013

[11] FoxNews.com Boom: Google Zooms 13% to a Record High; Market Cap Tops $335B October 18, 2013

[12] S&P Dow Jones McGraw Hill Financial S&P 500 Indices Fact Sheet

[13] Jeffe Macke Is Google Worth $1,000 a Share? Yahoo.com October 18, 2013

[14] Google Investor Relations Google Inc. Announces Third Quarter 2013 Results

[15] Yahoo Finance, Google Inc. (GOOG) Key Statistics

[16] The Wall Street Journal Market Data Center US Stocks

[17] 4-traders.com Google Inc (GOOG)

[18] Businessinsider.com Google's Secret Project 'Genie' Could Transform The Construction Industry October 18, 2013

[19] Bloomberg.com VIX 21% Tumble Means Shorts on Volatility Double Money October 17, 2013

[20] Tradingeconomics.com FRANCE INDUSTRIAL PRODUCTION

[21] Tradingeconomics.com FRANCE UNEMPLOYMENT RATE

[22] Tradingeconomics.com FRANCE LOANS TO PRIVATE SECTOR

[23] Bloomberg.com France Loses Top Credit Rating as Fitch Cites Lack of Growth July 13, 2013

[24] Fox News.com Senate budget deal provides back pay for furloughed federal workers October 16, 2013

[25] Abcnews.com $174,000 to a Senator’s Widow and Other Surprises in the Fiscal Compromise Bill October 16, 2013

[26] See Quote of the Day: There is now No Limit in government borrowing October 18, 2013

[27] US Congress H.R.2775 - Continuing Appropriations Act, 2014

[28] The Foundry Debt Ceiling with $300 Billion in New Debt, Heritage Foundation, May 19, 2003

[29] Washington post U.S. debt jumps a record $328 billion — tops $17 trillion for first time October 18, 2013

[30] Brilling.com U.S. NATIONAL DEBT CLOCK

[31] Lance Roberts The Long Game Of Hiking The Debt Ceiling STA Wealth October 11, 2013

Quote of the Day: There is now No Limit in government borrowing

Last night, after more than two weeks of utterly embarrassing theater, the government in the Land of the Free inked a deal to kick the can down the road a few more months. And in doing so, they set a very dangerous precedent.

As part of the bargain codified in HR 2775 (which President Obama signed into law), the Treasury Department is authorized to SUSPEND the debt ceiling. In other words, for all intents and purposes, there is now NO LIMIT government borrowing.

This limitless borrowing authority will expire on February 7, 2014. But it sets the precedent that dismissing the debt ceiling is a perfectly viable course of action.

Congress has effectively removed their handcuffs… so you can almost assuredly bet down the road that this provision will be extended, and ultimately become permanent.

This is from Simon Black of the Sovereign Man. The details of the slippery slope towards the unshackling of the debt handcuffs via HR 2775 can be found here; a summary can be found at Wikipedia. This reinforces my view that all the coming political debate on restraints on government spending will be about grandstanding, horse trading and theatrics.

US Politics: Despite the all the Theatrics the GOP Sells out, Debt Ceiling Raised

Today's US debt ceiling drama reminds me of a favorite Filipino proverb by my best friend and foreign client “Pagkahaba-haba man daw ng prusisyon, sa simbahan din ang tuloy” (“No matter how long the procession, it still ends up in church”)

Despite all the rhetoric, drama and theatrics about supposed "principles", the end game, as expected, has been to accommodate the perpetual propagation of debt.

As I previously noted

This means that despite the hullabaloo in the US Congress, which really is just a vaudeville, as congress people will fear the wrath of (the voting public-added Benson), losing political power and privileges from entitlement dependent-parasitical voters, eventually the debt ceiling will be raised. (charts from the Heritage Foundation).

Like actions of central banks led by the US Federal Reserve, America’s welfare state will be pushed to the brink of a crisis or will fall into a crisis first, before real reforms will be made.

In the world of politics, cost-benefit tradeoffs has been reduced to short term expediencies.

Now the compromise fires up the debt starved stock markets again, from the Bloomberg

U.S. stocks rallied, sending the Standard & Poor’s 500 Index (SPX) toward a record, as the Senate crafted a deal to end the government shutdown and raise the debt ceiling before tomorrow’s deadline.

The reported Senate deal: (bold mine)

The bipartisan leaders of the Senate reached an agreement to end the fiscal impasse and to increase U.S. borrowing authority. The Senate and House plan to vote on it later today, and the White House press secretary said President Barack Obama supports the deal.

The framework negotiated by Senate Majority Leader Harry Reid and Minority Leader Mitch McConnell would fund the government through Jan. 15, 2014, and suspend the debt limit until Feb. 7, setting up another round of confrontations.

The agreement concludes a four-week standoff that began with Republicans demanding defunding of Obama’s 2010 health-care law, and objecting to raising the debt limit and funding the government without policy concessions. House Speaker John Boehner said in a statement that Republicans won’t block the Senate compromise.

With no deal, the U.S. would exhaust its borrowing authority tomorrow and the government may start missing payments at some point between Oct. 22 and Oct. 31, according to the Congressional Budget Office. Fitch Ratings put the world’s biggest economy on watch for a possible credit downgrade yesterday, citing lawmakers’ inability to agree.

UPDATE the House of Representatives has reportedly acquiesced to the US Senate compromise.

And as I previously anticipated the GOP will sellout

And the fear of the wrath of the public which means losing political power have become a potent force in the shaping of the supposed deal…the American public has been putting the blame on the GOP (Republicans).

Here is House Speaker John Boehner statement on the Senate deal (hat tip Zero Hedge) [bold mine]

The House has fought with everything it has to convince the president of the United States to engage in bipartisan negotiations aimed at addressing our country's debt and providing fairness for the American people under ObamaCare.  That fight will continue.  But blocking the bipartisan agreement reached today by the members of the Senate will not be a tactic for us.  In addition to the risk of default, doing so would open the door for the Democratic majority in Washington to raise taxes again on the American people and undo the spending caps in the 2011 Budget Control Act without replacing them with better spending cuts.  With our nation's economy still struggling under years of the president's policies, raising taxes is not a viable option. Our drive to stop the train wreck that is the president's health care law will continue.  We will rely on aggressive oversight that highlights the law's massive flaws and smart, targeted strikes that split the legislative coalition the president has relied upon to force his health care law on the American people.

 

So the debt ceiling compromise will mark the 19th increase since March 1962. 

This also means that there will hardly be any reform until a crisis eventually hits.

At the end of the day, US politics end up where they started or from the default position of steadily raising debt. 

The Poker Bluffing circus never ends. The more things change...

A History of US Debt Defaults

Many mainstream pundits have been saying that the US hasn’t ever defaulted. This hardly represents the accurate picture of reality.

Austrian economist Joseph at the Mises Blog cites a work of another economist who noted of the previous US experience.

Ohio State economist J. Huston McCulloch actually challenges the conventional wisdom that the U.S. government has never, ever defaulted on its debts. McCulloch points out that the U.S. did indeed default on its debt in 1861 and again in 1933.  In 1861, the U.S. Treasury issued “United States Notes” to aid in financing the Civil War. These Treasury notes, known colloquially as “Greenbacks,” promised to pay the  bearer in “lawful money,” gold or silver at the government ‘s discretion, on demand. At the end of 1861, however, the government renounced its promise and suspended redemption as of January 1, 1862, putting it technically in default until 1879 when the notes were again made redeemable in gold. In 1933, President Roosevelt reneged on the promise to pay the interest and principal on Treasury bonds in gold at the rate of $20.67 per ounce, which once again put the government in technical default. In 1935, the right to redeem the bonds in gold was restored to foreign bondholders only, but at the depreciated rate of $35.00 per ounce, an option which was never offered to U.S. bondholders.

More important, the whole notion that an honest and explicit debt default by the U.S. government is an unprecedented event and the worst possible outcome in the current situation is ludicrous given that the U.S. has been continually and surreptitiously defaulting on its debt since World War 2 via inflationary finance. As McCulloch argues:

Governments often effectively default on their debts through inflation. Under a fiat money regime, they can always print enough legal tender money to pay off their debts. The only catch is that the money will not be worth as much as it was before. If it tries to cover too much deficit spending in this manner, more than a few percent of GDP, the inevitable result is hyperinflation in which money quickly becomes virtually worthless.

Disastrous though an explicit Treasury default would be, bringing down the entire economy with a hyperinflation or even a partial inflationary default would be even worse. But if we keep charging current deficits to future taxpayers at our current rate, the inevitable result will be a revolt in which they either explicitly repudiate all or part of the debt, or, worse yet, inflate it away.

Even the Wikipedia, as shown above, has an account of the history of US debt defaults as I previously posted here

Of course relationships have materially changed. This means that the effects of the previous defaults may or may not be the same as today.

However populist politics, which has been deeply immersed in the culture of debt, have used the default bogeyman as leverage to spook the markets in order to impel for the raising of the debt ceiling. Raising the debt ceiling means to persist on the path of a debt financed spending splurge. 

But this would be tantamount to playing with fire.

As I previously pointed out, the likelihood is that a debt deal will be struck perhaps in the last minute of the deadline, as politicians will hardly be fighting for principle, but for social standings and the maintenance of political privilege. Importantly a default would likely mean the end of the US dollar hegemony.

Proof of this can be seen in the recent editorial by the Chinese state press agency, Xinhua, which even called for the de-Americanization of the world where they claim that “effective reform is the introduction of a new international reserve currency that is to be created to replace the dominant U.S. dollar”

Nonetheless given the path of unsustainable debt absorption by the US government…

…which has also been reflected on the entire US political economy, the issue of default, directly (restructuring or repudiation) or indirectly (via massive inflation) is a question of when and not an if. 

This means that US politics should reform the system even at the cost of temporary instability, to prevent the day of reckoning.

Shutdown-Debt Ceiling Politics: The Charles Schumer Put

Step aside Alan Greenspan and Ben Bernanke. New York Senator Charles Ellis ‘Chuck’ Schumer has declared that the preservation of stock market has to be prioritized from the shutdown-debt deal stalemate.

From the Zero Hedge: (bold-italics original)

We commend Senator Schumer for being the first Senator to openly step up and admit that the worst case scenario in the whole Congressional 3D IMAX farce is not about keeping the economy afloat, is not about preserving jobs, but merely keeping the stock market at or near its all time highs:

• Schumer Says He Worries About Monday Stock Drop on Default Risk. "This is playing with fire," Sen. Charles Schumer, D-N.Y., tells reporters. Says he worried whether “the stock market will go down”

For those confused, Schumer has merely admitted what the vast majority of the Senate, where two thirds are millionaires, and nearly half the House, think: don't you dare let the manipulated precious, which at last check was just 1% below its all time Fed-balance sheet derived highs, drop.

And speaking of Chuck Schumer's "bottom line", here it is.

Bluntly stated; protect my investments and the interests of my campaign contributors

Shutdown Politics: Defying Yorktown’s National Park Service

Bureaucrats use the recent government shutdown to send a message to Washington, particularly the Republicans, instead, they got a pushback from the public.

From Austrian economist Gary North at the LewRockwell.com

A restaurant owner in the Colonial National Historical Park in Yorktown was told by the National Park Service to close his restaurant. The Park Service does not own it. It leased the building to the owner. It unilaterally broke its lease.

He closed it for a few days. Then he re-opened it.

The Park Service now has a huge public relations problem. It can choose to enforce its order. It can send in armed men to force the closing. Or it can just ignore this act of defiance.

The media have picked up the story as a human interest story. In this story, the Park Service is the villain — a bureaucratic agency trying to force the Republicans in the House to raise the debt ceiling. “Shut it down!” This mentality led to the closing of various Washington monuments. It has backfired on the senior-level bureaucrats who came up with this policy. First, a bunch of World War II vets removed the barriers, and walked into the monument area. Now a restaurant owner is doing the same thing.

What’s a bureaucrat to do?

It is significant that the restaurant owner is taking his stand in Yorktown. This makes the Park Service’s PR problem even worse. Yorktown is where George Washington, with help from the French fleet, defeated General Cornwallis in October 1781. That defeat ended Great Britain’s resistance to the American Revolution. The Park Service wants to be seen as George Washington. Instead, it is being seen as Cornwallis. It is going to lose this PR battle. It’s the bureaucratic world turned upside down.

This confirms North’s law of bureaucracy: “Some bureaucrat will eventually enforce a regulation to the point of utter imbecility.”

Why a US debt default extrapolates to the END of the US dollar hegemony

I previously pointed out from the public choice perspective why a debt default today by the US government is unlikely and has mostly likely been part of the political theatrics in the contest of power.

Politicians will hardly fight for an unpopular cause or principle, particularly against a system deeply hooked on entitlement or dependency programs, which will only cost them their careers and their privileges as political leaders.

The two-day bacchanalia by US equity markets where the Dow Jones Industrial skyrocketed by 434 points or 2.9% is a testament to this chronic addiction to the entrenched debt based entitlement culture. 

There is another major reason why the US the default card serves as another political poker bluff: A debt default extrapolates to the END of the US dollar hegemony.

Writing at the Project Syndicate, economist and political science professor Barry Eichengreen spells out the likely consequences of a US debt default. (hat tip Zero Hedge) [bold mine, italics original]

But a default on US government debt precipitated by failure to raise the debt ceiling would be a very different kind of shock, with very different effects. In response to the subprime disruption and Lehman’s collapse, investors piled into US government bonds, because they offered safety and liquidity – prized attributes in a crisis. These are precisely the attributes that would be jeopardized by a default.

The presumption that US Treasury bonds are a safe source of income would be the first casualty of default. Even if the Treasury paid bondholders first – choosing to stiff, say, contractors or Social Security recipients – the idea that the US government always pays its bills would no longer be taken for granted. Holders of US Treasury bonds would begin to think twice.

The impact on market liquidity would also be severe. Fedwire, the electronic network operated by the US Federal Reserve to transfer funds between financial institutions, is not set up to settle transactions in defaulted securities. So Fedwire would immediately freeze. The repo market, in which loans are provided against Treasury bonds, would also seize up.

For their part, mutual funds that are prohibited by covenant from holding defaulted securities would have to dump their Treasuries in a self-destructive fire sale. Money-market mutual funds, virtually without exception, would “break the buck,” allowing their shares to go to a discount. The impact would be many times more severe than when one money-market player, the Reserve Primary Fund, broke the buck in 2008.

Indeed, the entire commercial banking sector, which owns nearly $2 trillion in government-backed securities – would be threatened.Confidence in the banks rests on confidence in the Federal Deposit Insurance Corporation, which insures deposits. But it is not inconceivable that the FDIC would go bust if the value of the banks’ Treasury bonds cratered.

The result would be a sharp drop in the dollar and catastrophic losses for US financial institutions. Beyond the immediate financial costs, the dollar’s global safe-haven status would be lost.

It is difficult to estimate the cost to the US of losing the dollar’s position as the leading international currency. But 2% of GDP, or one year’s worth of economic growth, is not an unreasonable guess. With foreign central banks and international investors shunning dollars, the US Treasury would have to pay more to borrow, even if the debt ceiling was eventually raised. The US would also lose the insurance value of a currency that automatically strengthens when something goes wrong (whether at home or abroad).

The impact on the rest of the world would be even more calamitous. Foreign investors, too, would suffer severe losses on their holdings of US treasuries. In addition, disaffected holders of dollars would rush into other currencies, like the euro, which would appreciate sharply as a result. A significantly stronger euro is, of course, the last thing a moribund Europe needs. Consider the adverse impact on Spain, an ailing economy that is struggling to increase its exports.

Likewise, small economies’ currencies – for example, the Canadian dollar and the Norwegian krone – would shoot through the roof. Even emerging-market countries like South Korea and Mexico would experience similar effects, jeopardizing their export sectors. They would have no choice but to apply strict capital controls to limit foreign purchases of their securities. It is not inconceivable that advanced countries would do the same, which would mean the end of financial globalization. Indeed, it could spell the end of all economic globalization.

Once the confidence on the US dollar as a global reserve currency collapses, the outcome will be massive protectionism,  a horrific devastation of the global economy, widespread social unrest and worst, this will likely trigger a world war.

But the above doesn’t go far enough. Aside from global central banks taking a hit from their US dollar reserve holdings, the banking system outside the US will also come under duress or face the risks of collapse as the value of US dollar portfolios (reserves, assets and loan exposure) plunge. 

The highly leveraged currency markets itself will likely fail or seize up. The US dollar constitutes 87% of the $5.3 trillion currency market trades a day under today’s circumstances or conditions.

Domestic defaults, considering the  vastly expanded debt levels are likely to explode as financial flows freeze.

This will be compounded by a standstill of trade and economic activities, which should severely affect the the banking system’s loan portfolios.

And the icing in the cake will likely be a crash of financial markets, where financial assets makes up a key part of the banking sector’s balance sheet.

And given the systemic defaults ex-US government bonds are unlikely to function as safehaven too.

As of the 2nd quarter of 2011, US bonds account for 32% of the $99 trillion global bond markets which about half are government bonds.

And there surely will be huge impact on the global derivative market at $633 trillion as of December 2012

In short ramifications from a contagion of a US dollar collapse seems incomprehensibly catastrophic.

Given this scenario, I am not persuaded that ex-US dollar currencies will rise in the face of a US dollar meltdown.

This assumption will hold true only if ex-US banks have been prepared for such a dire scenario which is a remote possibility. 

But the fact that the US dollar remains a major part of the global foreign currency reserve system demonstrates the continued dependency by the world on the US dollar.

The global banking system whose architectural foundations has been built on the US dollar system are likely to disintegrate too along with the US financial system.

In my view, a collapse of the US dollar standard will extrapolate to the destruction of the incumbent paper money standard. The world will be forced to adapt a new currency standard, whether gold will play or role or not is beside the point. 

Yet I would like to add that the US Federal Reserve holds $2.87 trillion of US treasuries according to the weekly updates on the Factors Affecting the Reserve Balances as of October 9th. The accounting entry by the USTs held by the FED are at “face value” which according to them is  “not necessarily at market value”

This also means that the Fed is susceptible huge losses even if the Fed can resort to changes in accounting treatment to evade insolvency.

The bottom line is that if all the FED’s credit easing programs has been meant to shore up the unsustainable debt financed political system anchored on privileges for vested interest groups operating under troika of the welfare-warfare state, crony banking system and the US Federal Reserve, a debt default would essentially negate the FED’s actions, annihilate such political economic arrangements and importantly leads to the loss of the US dollar standard hegemony.

These are factors which the political “power that be” will unlikely gamble with, lest lose their privileges.

Yet given the persistence of the current debt financed deficit spending and other political spending trends, a debt default and a market driven government shutdown signifies as an inevitable destiny.