The document summarizes recent trends in the US bond and stock markets, and discusses their implications. It notes the large and growing US budget deficits and debt levels, which are projected to exceed 100% of GDP. It also discusses concerns around failed government bond auctions, China reducing its Treasury holdings, and potential problems in the US housing market that could lead to another taxpayer bailout.

1. Agcapita Macro Update
October 2009
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2. Summary
There has been considerable discussion recently about the
“paradox” of bonds and stocks and commodities going up together
- that the bond market is predicting a continuing recession via low
interest rates and the stock market is predicting a recovery via high
equity prices. Why is the bond market behaving so strangely in the
face of a huge recovery stocks and commodities – surely one of
these indicators must be wrong? Maybe, but perhaps there is an
alternative interpretation that fits the facts.
Markets always appear to act strangely to profit maximisers when
non-profit maximisers are involved. I actually feel that the behavior
of the sovereign debt market makes sense. Virtually every asset
class is exhibiting the short-term effects of a massive monetary
expansion. Once again assets that are liquid and traded - including
LT sovereign debt – are rapidly “increasing” in price in nominal
terms. Monetary authorities have expanded the global money
supply aggressively allowing speculative activities to re-ignite via Contents
investment and commercial banking intermediaries and at the same 2 US Fiscal Deficit
time they are busy monetizing the rapidly expanding government 2 Failed Government Bond Auction
debts - hence low interest rates and rapidly recovering equity prices.
2 US Sovereign Debt:
When cross-correlations between assets classes are very high and 2 Unfunded Debt and Obligations
positive we should always be asking ourselves whether we are in a 3 China Reducing Its Treasury
period of liquidity/money printing induced euphoria.
Duration
Ultimately monetary authorities can control exchange rates or 3 Another US Bailout in the Wings?
interest rates but not both. If they decide to sacrifice exchange 4 More Trouble on the Way in the
rates for low interest rates then, in my opinion, inflation is sure to Banking System
follow.
5 Hyperinflation – Quick Facts
Kind Regards
Stephen Johnston - Partner
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3. Global Macro Update
Us FisCal DeFiCit
By the end of 2019, according to the administration’s If you were a foreign government, would you want to
budget numbers, the US federal debt will reach increase your holdings of Treasury securities knowing
$23.3 trillion—as compared to $11.9 trillion today. the U.S. government has no plans to balance its
The U.S. federal debt was equal to 61.4% of GDP in budget during the next decade, let alone achieve a
1999, 70.2% of GDP in 2008 and is now projected surplus?
to increase 90.4% in 2009 ultimately reaching 100%
in 2011, after which the projected federal debt will FaileD Government BonD aUCtion
continue to equal or exceed the US’s entire annual
economic output through 2019. The Debt to GDP Latvia recently tried to raise US$17 million worth of
ratio effectively measures a nation’s capacity to 6-month bonds. How likely is it that Latvia will default
generate sufficient wealth to repay its creditors. The in the next six months? Unlikely, and yet the auction
U.S. is thus on track to enter the ranks of those failed with no bids. When lenders lose confidence
countries—Zimbabwe, Japan, Lebanon, Singapore, in a government’s ability to repay, the consequences
Jamaica, Italy—with the highest government debt- can be swift and total - they refuse to lend it money.
to-GDP ratio. In 2008, the U.S. ranked 23rd on the
list—crossing the 100% threshold vaults the US into Us sovereiGn DeBt
seventh place.
Lenders are still willing to provide the US government
30 year financing at a 4% annual yield. For three
Chart 1: Deeper in DeBt month funding they only charge the US government
0.066%. For a government heading into massive
Budget surplus/deficit As percentage and prolonged fiscal deficits this seems somewhat
(in billions) of GDP generous on the part of the markets.
$500 5%
surplus projections UnFUnDeD DeBt anD oBliGations
deficit
0
The Obama Administration, unaware or ignoring the
500 -5 fact that the total unfunded debts and obligations of
1000 -10
the federal government have grown to nearly $120
trillion, continues to pursue a policy of massive fiscal
1500 -15 deficits.
2000 -20
1970s 1980s 1990s 2000s 2010s
Source: OMB (historical); Committee for a Responsible
Federal Budget, CBA (projections)
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4. Global Macro Update (continued)
another Us BailoUt in the WinGs?
Chart 2: total U.s. DeBt as a
perCent oF GDp A year ago the US government took over Fannie Mae
and Freddie Mac to prevent them from failing. Now
1,200 1142 the Federal Housing Administration appears “destined
1012 1025 for a taxpayer bailout in the next 24 to 36 months”
1,000 according to Edward Pinto at a recent Congressional
hearing. Edward Pinto, of course, is the former
800
chief credit officer for Fannie Mae so perhaps he is
600 speaking from experience.
400
311
FHA has managed to repeat all of Fannie and
263 Freddie’s mistakes – which of course was what was
200 hoped would happen. The FHA stepped in and
87
became a huge player in the mortgage loan markets
0
specifically to replace the crippled Fannie and
Gross Federal, add; add; GSE add; SS/ add; Foreign add; Financial
State & Local Household, Medicare held sector Freddie. The proof is in the data - FHA went from
Gov’t Business
insuring 6% of new mortgages in 2007 to over 21%
Source: Federal Reserve Z 1, FHFA GSE Report 2008/ last year and accelerating in 2009.
RGE Monitor, Richard W Fischer (“Storms on the Horizon,”,
Dallas Fed 5/28/2008), Rather & Kittrell What does that portfolio look like? The FHA insures
5.4 million single-family home mortgages - most
of which require only a 3.5% down payment - at a
value of $675 billion. At the same time the FHA has
China reDUCinG its treasUry DUration
only $30 billion in capital – a 20-1 leverage level that
How to start getting out of the dollar while not proved too much for some of the largest investment
appearing to be getting out of the dollar? One way banks and insurance companies in the world. Of
is to shorten the duration of your bond holdings or to course when you provide credit that the market will
announce purchases of hard asset denominated in not, you suffer default rates that reflect the risk you
dollars. This is exactly what is happening. China, for are taking on. FHA defaults rates are starting to
instance, continues to accumulate Treasuries -- but increase rapidly.
only short-term notes, not long-term bonds -- while
buying up real assets like oil fields and iron ore mines.
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5. Global Macro Update (continued)
2009) the index has recorded a 22% drop in value.
Chart 3: loan portFolio DeFaUlt rate
The quality of commercial real estate loans held by
Default Rate banks is going to be seriously impaired soon.
2007 loans
30%
2006 loans
2008 loans 20 Chart 4: CommerCial real estate
2005 loans
(% ChanGe)
10 25%
2004 loans 20%
15%
0
10%
1 2 3 4
Years since loans were made 0%
-5%
Source: FHA, The NY Times
-10%
-15%
1978 1980 1982 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
more troUBle on the Way in the BankinG
system Source: NCREIF Commercial Real Estate Index data
Over the last decade commercial real estate boomed.
All over the globe developers borrowed trillions
to build office towers, malls and industrial parks The magnitude of this problem will be as big as
based in part on the belief that prices and rents the problem caused by loan losses on residential
would rise for the foreseeable future. The National housing and as widely spread throughout the global
Council of Real Estate Investment Fiduciaries banking system. Banks cannot continue to carry
(NCREIF) is an association of institutional real estate these commercial real estate loans on their books at
professionals. The NCREIF Property Index is a face value. Commercial borrowers cannot refinance
quarterly time series composite total rate of return their loans if the property isn’t worth as much as
measure of investment performance of a very large the debt. Trillions of dollars of commercial real
pool of individual commercial real estate properties estate loans are coming due and the recession has
acquired in the private market for investment caused occupancy levels and rents to fall and, with
purposes only. The NCREIF index makes it clear that them, property values. The appearance that the
one of the largest drops in US commercial real estate commercial real estate market has held up better
values is currently underway and it is still the early than the residential market to date is an accounting
innings. Over the last four quarters (3Q 2008-2Q fiction. The new mark-to-market accounting rules
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6. Global Macro Update (continued)
have allowed banks to delay reporting loan losses intertwined worlds of politics and economics with
until their loans mature – rather than mark them to special attention given to money. In his most recent
market. The rules also allow commercial real estate book, Monetary Regimes and Inflation: History,
owners from reporting investment losses until they Economic and Political Relationships, Bernholz
sell the property. The losses are still there and will analyzes the 12 largest episodes of hyperinflations
begin to crystallize as loans fail to roll-over and - all of which were caused by financing huge
owners go under. The stock prices of commercial public budget deficits through money creation. His
property REITs should start to reflect these conclusion: the tipping point for hyperinflation occurs
deteriorating fundamentals. REITS hold billions in when the government’s deficit exceeded 40% of its
commercial property investments that will have to be expenditures.
marked down. The banking sector will also suffer as
the magnitude of these loan losses will be equal to or “According to the current Office of Management and
perhaps even exceed the losses suffered from loans Budget (OMB) projections, US federal expenditures
made to the residential real estate sector. are projected to be $3.653 trillion in FY 2009 and
$3.766 trillion in FY 2010, with unified deficits of
hyperinFlation – QUiCk FaCts $1.580 trillion and $1.502 trillion, respectively. These
projections imply that the US will run deficits equal to
I want to quote a recent article by high profile financial 43.3% and 39.9% of expenditures in 2009 and 2010,
analyst John Maudlin. Its makes fascinating reading. respectively. To put it simply, roughly 40% of what our
government is spending has to be borrowed.
“Killing the Goose” by John Mauldin
“One has to ask whether the US reached the critical
“Western democracies, communistic capitalists, and tipping point. Beyond the quantitative measurements
Japanese deflationists are concurrently engaging in associated with government deficits and money
what may be the largest, global financial experiment creation, there exists a qualitative aspect to such
in history. Everywhere you turn, governments are a scenario that may be far more important. The
running enormous fiscal deficits financed by printing qualitative perceptions of fiscal and monetary policies
money. The greatest risk of these policies is that are impossible to control once confidence is lost.
the quantitative easing will persist until the value of In fact, recent price action in metals, the dollar and
the currency equals the actual cost of printing the commodities suggests that the market is already
currency (which is just slightly above zero). anticipating the future.”
“There have been 28 episodes of hyperinflation of Let me point out that the deficits for 2010 assume
national economies in the 20th century, with 20 a rather robust recovery, and so they could turn
occurring after 1980. Peter Bernholz (Professor out to be much worse, especially if unemployment
Emeritus of Economics in the Center for Economics continues to rise and Congress decides (rightly) to
and Business (WWZ) at the University of Basel, extend unemployment benefits. The interest on the
Switzerland) has spent his career examining the national debt in fiscal 2008 was $451 billion. Even
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7. Global Macro Update (continued)
though the debt has exploded, the interest for fiscal
2009 is down to “only” $383 billion. My back-of-the-
napkin estimate says that is over 20% of total 2009
tax receipts. I guess when you take interest rates to
zero and really load up on short-term debt, it helps
lower interest costs.
The fiscal deficits are projected to be about 11% of
nominal GDP, which is now roughly $14.3 trillion. The
Congressional Budget Office currently projects that
deficits will still be $1 trillion in ten years. Last spring
I published as an Outside the Box a very important
paper by Dr. Woody Brock on why you cannot grow
government debt well above nominal GDP without
causing severe disruptions to the overall economic
system. I am going to reproduce just one table from
that piece. Note that this was Woody’s worst-case
assumption, adding 8% of GDP to the debt each
year, and not the 11% we are experiencing today.
The Congressional Budget Office projections are now
even worse, and that assumes a very rosy 3% or
more growth in the economy for the next five years.
Under Woody’s scenario, the national debt would
rise to $18 trillion by 2015, or well over 100% of GDP,
depending on your growth assumptions.”
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