Happy Birthday America

Happy Birthday America
July 4, 2009

As we celebrate the nation’s birthday, we may wish to be mindful of the stress that many in our country are under.  We may try to be gracious in the face of adversity.  We can pause.  And reflect.  And give aid.

On Friday, in New York, I watched a caring person take 15 minutes to escort a blind woman to her home.  They were strangers.  There was construction on the street and the blind person needed some guidance.  Many passed her by, but thankfully not all.  Kindness to a stranger is a value that doesn’t get measured in our national GDP.  It gets counted when each of us looks in the mirror.

Two close personal friends sent me the email that I will quote below.  It is sourced to a Washington Post story; that link is below as well. It will inspire us as the grill is lighted and the chicken sizzles.  America will weather this economic storm if it does not lose its humanity.  The risk of that loss is a far greater threat than the federal deficit.

The email story follows:

“Washington, DC Metro Station on a cold January morning in 2007. The man with a violin played six Bach pieces for about 45 minutes. During that time approx. 2 thousand people went through the station, most of them on their way to work. After 3 minutes a middle-aged man noticed there was a musician playing. He slowed his pace and stopped for a few seconds and then hurried to meet his schedule.

4 minutes later:

The violinist received his first dollar: a woman threw money in the hat and, without stopping, continued to walk.

6 minutes:

A young man leaned against the wall to listen, then looked at his watch and walked on.

10 minutes:

A 3-year-old boy stopped, but his mother tugged him along hurriedly. The kid stopped to look at the violinist again, but the mother pushed hard and the child continued to walk, turning his head all the time. This action was repeated by several other children. Every parent, without exception, forced their children to move on quickly.

45 minutes:

The musician played continuously.  Only 6 people stopped and listened for a short while. About 20 gave money but continued to walk at their normal pace.  The man collected a total of $32.

1 hour:

He finished playing and silence took over. No one noticed. No one applauded, nor was there any recognition.

No one knew this, but the violinist was Joshua Bell, one of the greatest musicians in the world. He played one of the most intricate pieces ever written, with a violin worth $3.5 million dollars. Two days before Joshua Bell sold out a theater in Boston where the seats averaged $100.

This is a true story. Joshua Bell playing incognito in the metro station was organized by the Washington Post as part of a social experiment about perception, taste, and people’s priorities. The questions raised: in a commonplace environment at an inappropriate hour, are we able to perceive beauty? Do we stop to appreciate it? Do we recognize talent in an unexpected context?  One possible conclusion reached from this experiment could be this:  If we do not have a moment to stop and listen to one of the best musicians in the world, playing some of the finest music ever written, with one of the most beautiful instruments ever made, how many other things are we missing?”

For details see the story by Gene Weingarten, Washington Post staff writer, Sunday, April 8, 2007; page W10.  The link is: http://www.washingtonpost.com/wp-dyn/content/article/2007/04/04/AR2007040401721.html .

Now to some economics as we celebrate America’s birthday.

The United States has been debt-free in only two years of its existence, 1834-5.  We experienced hyperinflation as a fledgling republic. The phrase “not worth a Continental” referred to the continental dollar used to finance the Revolutionary War, and not to a car manufactured by Ford Motor Company.  We have also had deflation in double digits during the Depression era. Neither hyperinflation nor severe deflation is currently in the forecast horizon.

At a level of about $11.5 trillion, we are presently trending to a debt/GDP ratio of 85%.  At the end of World War II that measure of debt burden peaked at 120%.  If current trends of net new borrowing of over $100 billion a month continue, we are likely to exceed that wartime record.  The annual interest burden is approaching a half a trillion dollars and grows as the debt ratio grows.  This will intensify once higher interest rates occur.

In sum, the debt burden is large and growing.  It may not be inflationary in the short term because of the recession.  It will be inflationary in the longer term unless the Fed exits its massively stimulative strategy in a precisely executed process.  History says central banks do not do these things with precision.  That means there is a high risk of a policy failure, because the Fed may either move too soon or wait too long.  Members of the Fed are required to operate with forecasts.  And they, too, are human.

On this birthday weekend, one in ten workers is looking for a job and cannot find one.  One in six is underemployed, which means many have some job but at much less income than in their previous experience.  The average hourly work week is stagnant.  While the unemployment rate is a lagging indicator, the work week is a contemporaneous one.  It will have to rise in order for things to start improving.  So will measures of labor income.  Neither is happening, so the turnaround is not yet at hand.

In a provocative research comment on July 3, 2009, David Woo of Barclays Capital uses three data series to derive a model of the impact of the growing federal deficits on the US dollar/euro exchange rate (EUR/USD).  He ends with a forecast that a “5% increase in the outstanding stock of US Treasuries relative to eurozone government bonds is associated with an 8% depreciation of the USD on average.”  Woo studied the period of 1999 to present.  The euro started its trading existence on January 1, 1999.

Woo also notes that low “substitutability between eurozone government bonds and Treasuries” is indicative of a market now driven by “central banks” and government institutions. That means interest rate differentials between these two groups are now a less powerful factor in determining the outcome of the EUR/USD exchange rate.  His math supports this conclusion and suggests the forthcoming and ongoing large US federal deficits will weaken the US dollar.  Woo’s one-year forecast is for a EUR/USD exchange rate of 1.50.

Impressive within Woo’s work is how he estimated the temporary effect of a flight to quality into the US dollar.  He used the VIX as a measure to determine when the spread between eurozone government bond yields and Treasury yields widened during crisis response periods.  The VIX effect is temporary but powerful when it happens.  A VIX spike can result in a dollar rally and lower Treasury yields, which seems counterintuitive to many market agents.  Markets may want to pay close attention to this measure offered by Woo, since it is the longer-term trend that prevails.

Since we believe the outlook for US fiscal policy is bleak for the next decade, we extended Woo’s work beyond his one-year time horizon.  We accepted the Congressional Budget Office estimate that the annual Obama deficits will exceed $1 trillion for the next ten years.  In fact, we expect that the cumulative deficit will be higher than the CBO estimates, because we believe that our political system is currently heavily biased towards borrowing instead of taxation.  Those assumptions lead us to a 1.60 to 1.70 EUR/USD in the early part of the next decade and a longer-term level of 2.0 or higher as the decade progresses.

What a way to start the Fourth of July celebration!  Woo titled his piece “USD risk premium, US fiscal profligacy and the ‘portfolio effect’.”

Enjoy your holiday weekend.  Happy Birthday America!

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com