Monday, December 08, 2008

The Risk in "Risk-Free" US Bonds

Find the premise which is false and bet against it - George Soros

Bubbles, as so aptly described by George Soros, generate their own rationales, which are later exposed as false.

The most recent bubble, or so I see it, in the US Bond market is no exception. One of the more prominent (and false) reasons given for the flood of money seeking safety in the US Bond Market is their "risk-free" status. According to many investors therein, US Bond investments are "guaranteed"- the US Government won't default.

This is true. However, the only US Government guarantee (now that there is no link between the US$ and Gold or other specie) implicit in US Bond investments is that the Fed and Treasury will, in the event of a shortfall, create as many $s as needed to make Bond and (given the shortened duration of US Federal debt) Bill investors "whole."

The key then, it seems to me, is determining when such money creation will be needed.

Like any other bond analysis, the main issue is cash flow- is the Treasury taking in enough $s to meet its obligations? More to the point, what trends are evident in the data that suggest ease or difficulty in meeting those obligations.

After checking the Treasury (FMS) site, I see that Federal Tax receipts are (on a 12M rolling sum) down 2.6% y/y while expenses are up and expected to rise much further over the coming months.

Leaving aside the issue of tax rates, Federal Tax receipts are (obviously) highly correlated to personal income and, lately, quite dependent on corporate profits. One of the features of the Bush regime, and to a lesser extent the preceding Clinton years, has been an increase in corporate profits relative to personal income. In 1970 personal income was 10 times corporate profits. In 1980 personal income was 11.4 times corporate profits. During the Bush years, personal income averaged 8.4 times corporate profits.

Thus, swings in corporate profits have increasingly impacted Federal Tax receipts as the graph below shows.

With Unemployment rising in the US, personal income is unlikely to rise and should fall further. This, combined with recent US$ strength is likely to weigh on corporate profits going forward. Consequently, and perhaps in accelerating fashion given recent US$ strength, US Federal Tax receipts should continue to fall.

In my view, either the Treasury defaults on its debt or it prints money in increasing amounts to "make good." In either event the value of the US$ falls.

Sadly, it seems to me, US policymakers, and their Chinese counter-parts (neither of whom, it seems, wishes to "blink") have missed the opportunity for a graceful (at least relative to the alternative) inflation (dilution of US$ liabilities). China's intransigence in letting the Yuan rise against the US$, and indeed forcing its decline- abetted by US reluctance to lose the ability to print the world's major reserve currency- has only exacerbated the decline in US real sector activity and thus further reduced Federal Tax receipts.

There is, as they say, no free lunch. Chinese purchases of US Bills and Bonds and thus the US$ will only, by virtue of the trends depicted in the graph above, hasten the day of reckoning when it's print or default.

In this game of financial "chicken" the winner is the guy who blinks first.


Saladin said...
This comment has been removed by the author.
Saladin said...

I think it was Winston Churchill who said "the US can be counted on to do the right thing, eventually...".

Do you agree that we will get the inflation that is needed to deflate the debt burden? Or, do you think that the debt holders will greedily hold on to their claims untill we all go careening of the proverbial deflationary cliff?

Saladin said...

So to hog you blog.

Have you seen this?

Is this horse-sh1T or for real?