An Empire of Debt

December 14, 2010

The Fed has just announced it's continuation of zero interest rates and the QE2 program. As I glance at the ticker, the ten year yield has risen to 3.44 and gold has moved up to 1406. What a surprise! I say that the Empire of Debt, the good old USA, is showing early signs of decay. It took quite a while for Rome to falter and implode, only because they didn't have access to a bond market. Our bond market is showing signs of stress.

Now clearly, bonds are oversold and one can expect a countertrend move in the near future but I think that a secular low in bond yields has been put in place over the past few years and yields will inexorably move up in the future. There is a wide disparity of opinions regarding how high and over what time frame this trend will occur. Bill Gross, Mr Bond, feels that yields will level out at approximately 3.5% feeling that growth will be about 2% and Inflation about 1.5%. On the other hand, there are those, those who loaded up on CDS investments prior to the implosion of 2008-9 like Paulsen, Julian Robertson and the one-eyed neurologist whose name I cann't recall, who feel that the ten year will rise to 20% within 5 years. Certainly, one's investment decisions will be predicated on which outlook one subscribes to.

I think that the Emporer has no clothes; the US is insolvent. Will we raise taxes and curtail entitlements for everyone in the near future to achieve a modicum of fiscal credibility? I doubt it. It is far more likely that the US defaults on it's debt. We did it before. In 1933, FDR changed the exchange rate for the $ from 17/ounce of gold to 35. I think Bernanke knows full well that the long term solution to the problem is to borrow in $ and repay later in wampum. Currently, there is a debate about the reasons for the bond market selloff. The consensus is that yields are rising in response to an improving economic outlook. Maybe, but in all due respect, Shelley, I am skeptical. Will most people spend more because their tax rates will not go up? Will businesses invest for the long term when everyone knows that the tax structure will be radically changed in two years?

Your President has told you that he will whack wealth and Capital in two years. The real estate market is our Achille's heel and one has to speculate that rising mortgage rates cannot be good for this area. Rising commodities, particularly food and gas cannot be good for discretionary spending. The other plausible explanation for the rise in interest rates would be increasing inflationary expectations. As proof, I offer the correlation between the TIPs market and rising yields. If the US economy is strengthening, why is the $ currently weak despite the euro's well documented problems? Gold continues in it's bull market.

To plagiarize, shamelessly, from James Grant, the price of gold = 1/n where n represents the credibility of noncollateralized paper currencies and central bankers. I suspect that the denominator of the equation will shrink with time. Therefore, I am bullish on gold. I am less so on the US Treasury market.

-Guga