Can U.S. Really Print Its Cake and Eat It, Too?

Good Evening: In contrast to recent sessions, U.S. stocks rose and then gave back the bulk of their gains on Tuesday. What’s interesting is that the source of both the rally and the sell off was the same news story — that President Obama and leaders in Congress have an agreement in principal (or, if you prefer puns, principle) to extend current tax rates for two years, long term unemployment benefits for 13 months, and various other fiscal stimulus measures for who knows how long. This “deal” will be a real test for our capital markets. Can we really borrow, spend, and just print the money with which to pay for it all?

Equities rejoiced at the news and surged at the opening bell, only to sink back later when the bond market shuddered at the massive supply of new paper this “deal” implies. Interest rates spiked across the board, but the 7 year note tacked on almost 25 bps in what looks like an assault on the confidence of Treasury investors who felt bullet-proof only a month ago. Those higher rates also caused perverse reactions in the currency and precious metals markets. The dollar index actually rose 0.3%, while gold and silver lost 2% and 4% respectively. The metals could sink further if recent longs fear rising dollar yields will prove tough competition to gold’s 0% yield, but investors should try to remember that currencies like the dollar (and gold) compete with each other based on short term interest rates, not long term rates. U.S. short rates still hug the ground and they will for the foreseeable future, given Mr. Bernanke’s promises on 60 Minutes over the weekend (see below). Long term thinking didn’t prevail this afternoon in the commodity pits, however, and the CRB index shed 0.5%

U.S. stocks may have given back most of their gains today, but they’ve powered ahead in recent weeks despite a litany of frightening headlines. The EU was able to extinguish its Greece fire this spring, but Ireland’s woes this autumn — with Portugal, Spain, and even Belgium nervously awaiting their turn in the Cuisinart of modern global credit — seemed to threaten the very existence of the EU and its currency. Not a day goes by without some dust-up between EU leaders or their ministers, but they all wear kid gloves compared to the real and imagined salvos that have been fired at times on the Korean peninsula. Hopes that China would rein in its truculent client state are dimming, since China seems more intent on measures that would contain inflation rather than North Korea. Investors have been constantly reminded that the world is indeed a dangerous place, even more so with WikiLeaks releasing the type of secret information that causes diplomats to reach for the blood pressure pills. And yet, global bourses have managed to rally.

The domestic news flow in the U.S. is hardly much better. Many state and local governments are hanging on by their fiscal fingernails, the unemployment rate is still rising, and the housing market remains so bad that it would have to improve to be called awful. QE II is off to such a rocky start that interest rates have actually risen in response, an outcome so vexing to Chairman Bernanke that he felt the need to appear on “60 Minutes” Sunday night to defend it. Our Chairman and others worry openly about the risk of deflation, but food, energy, and other items we tend to use every day are actually inflating. Finally, hopes that November’s election and President Obama’s bipartisan “Debt Commission” would lead to more responsible fiscal behavior in Washington were dashed last night on word of a deal to extend tax cuts AND increase spending (see below). And yet, the U.S. stock market has managed to rally.

Ignore for a moment the dangling question of “why?” and consider the market action we’ve seen in recent days. Whether it was Ireland sinking in a sea of debt, North Korea lobbing shells over the border, or a very weak employment report, stocks have found a decent reason to sink at the open of almost every recent trading session. Today was an exception, but many times in recent days equities have rallied back to finish near their highs, confounding bears, technicians, and just about anyone who can read a newspaper.

So why, despite Europe’s debt contagion, China’s tightening moves, North Korea’s militancy, dreadful housing and employment figures in the U.S., and Wiki’s enraging Leaks have stocks and precious metals managed to remain aloft? The answer is as simple as it is global: money-printing. As you will read in the articles below, Western governments and their central banks are fighting their debt and currency wars with freshly printed dollars and euros. The ECB’s Mr. Trichet gave in last week, and his bank has once again stepped up its bond purchases (see below). Our Fed and its Depression-fighting Chairman have now promised that if QE II isn’t enough, then perhaps QE III, IV, or V will do the trick. There are other factors behind Mr. Market’s northward march (i.e. shorts looking for deflation to emerge are being forced to cover and reassess), but money-printing and the promise of fiscal stocking-stuffers have been the wind behind the old gentleman’s back.

At least Great Britain and various governments on the Continent are attempting some austerity as they try to work through their debt issues. Our leaders here in the U.S., though, want nothing to do with fiscal discipline. Despite an electorate that wants debt reduction, and despite the advice of a bipartisan debt commission designed to give them political cover, our Congress and our President seem once again set on trying to give everyone what they want — no matter the cost. Why try to make the tough choices, so goes this rationale, when our central bank can just print enough money to buy up our spiraling debt issuance? Those who thought November’s election results meant either gridlock or responsible compromises must now face the sad reality that both parties have responded with what amounts to a bidding war to buy votes. If this is gridlock, this scribe wants no part of it.

Assuming this package of tax cut extensions, long term jobless benefits, corporate tax largesse, and a payroll tax holiday, etc. becomes law (which is not a given), the investment implications are mixed and dependent on time frames. The “risk on” trades are likely to benefit in the short run, while rising interest rates will pose increasing problems for all markets as time goes by — especially if funding the massive deficits going forward leads to a rocky outcome not unlike countries in peripheral Europe. Folks who don’t think a “sovereign run” (think: Greece/Ireland this year, or Argentina/Mexico in recent decades) can happen in the U.S. should think again. It almost happened here during the late 1970’s, when the dollar swooned, interest rates soared, and gold roared.

Though the U.S. was in better financial shape in 1979 (in terms of deficits & total debt as a percentage of GDP), it still took a courageous Fed Chairman (Paul Volcker) and the administration of painful medicine to slay a monstrous CPI. The double digit inflation of that miserable period took root during the preceding 10 years, when “guns & butter” fiscal policies (increased military spending due to Viet Nam & large increases in domestic spending programs) were accommodated by a timid Fed.

Flash forward to 2010 and we have similar issues (wars abroad & the promise of yet more fiscal candy out of Washington). It is of little wonder that Moody’s came out today and said: “We have long term concerns about the (U.S. credit) outlook and they are not yet being addressed. We’re waiting to see if they’re going to be addressed in the next couple of years,” (source: Reuters article below) The more influential voice known as the bond market was willing to wait a couple of years and registered its own stern protest today. It may take time, but the day is drawing nearer when, as Bill Fleckenstein likes to say, “the markets take away the Fed’s printing press”.

In closing, let me draw one further connection between today and the late 1970’s. In the 1978 hit movie, “Animal House”, a disgusted Dean Wormer admonishes Kent Dorfman, saying, “fat, drunk, and stupid is no way to go through life, son”. Well, borrow, spend, and print is no way run a responsible government, either. For this set of policies to work, it would mark the first time in history that a nation was able to print its cake and it eat, too.

– Jack McHugh

ECB Steps Up Bond Purchases to Fight ‘Acute’ Market Tensions
Bernanke Says Fed May Take More Action to Curb Joblessness
Obama Agees to Two Year Tax Cut Extension, Calls For Lower Payroll Taxes
Extension of U.S. Tax Cuts Will Prompt Congress to Disregard Own Budget Law
Moody’s worried U.S. tax cuts could become permanent

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