Forgive Us Our Debts.....

As regular readers know, one of the issues I've been harping on is the probability that the economic recovery that lies ahead might not live up to expectations in terms of its vigor. One of the main reasons I feel this way is the presence of pending consequenses of the drunken sailor spending binge the US Government is currently on (and it's showing absolutley no signs of jumping on the wagon anytime soon, by the way. See GM, GMAC, etc.). The consequences of large, unproductive spending programs are higher interest rates (as investors in our debt demand more interest), higher taxes (as the Government tries to find other ways to pay for spending programs), and a lower dollar (as the Treasury "creates" currency out of thin air - the more they print, the less it's worth).

I've always thought that a little logic goes a long way in looking at markets and picking stocks. Logic seems to be in short supply on the Street these days with everyone still pushing quantitative models and algorithmic trading no matter how many times they get burned by them. So be it: that works in our favor. While the consequences of massive Government spending are more than likely to play out in fits and starts over time, play out they will unless the prevailing attitude on the Hill changes quickly. It would be illogical for them to play out any other way. With this in mind, let's focus in on what's been happening in US Government Bond-land lately, as last week was an interesting one.

First, let's take a look at a couple of numbers:

1) The total U.S. debt last year = $9.4trln........Today = $11.3trln........'12 estimate = $14-15trln. ........U.S. GDP estimates = ~$13trln

2) Interest on U.S. debt = 4% of the total budget now...........Kiplinger estimate = 11% by '13

3) U.S. Government debt issuance is running at an average of slightly under $500bln/quarter. This is 7X the rate of issuance before the crisis hit.

4) We issued $101bln in debt last week alone.

5) Goldman estimates that the U.S. will sell $3.25trln of Treasuries in this fiscal year.

Want a little more perspective? Check out http://www.usdebtclock.org/

Now, S&P caused a big stir last week after it downgraded the UK's credit outlook from stable to negative, which got folks talking about the good old USA. S&P is concerned about the UK's debt load heading to 100% of GDP from 67% today, but they forgot to mention Uncle Sam's indebtedness. Nonetheless, it doesn't take a genius to realize that the U.S. is in exactly the same leaky, debt-laden boat as the UK in terms of where we are today (we're slightly worse off on the debt to GDP measure at 70%) and where we're headed tomorrow (by the way, as a point of reference, Canada's debt to GDP is currently at 29%. I smell a short U.S./long Canadian dollar pair trade here). While Moodys came out and affirmed the USA's AAA rating later in the week, helping the bond market get back on its feet, aren't the rating's agencies the ones that missed the ENTIRE mortgage mess in the first place??? Should we really be putting much faith in what they're telling us? All you have to do is a little basic math (and use, you guessed it, a little logic) to figure out where this boat is headed.

Sooooo the bond market gyrated on all of this news, with yields breaking out as investors wrung their hands about the new supply coming to market and the negative vibe that was hanging in the bond pits all of the sudden. However, a decent 7yr Treasury auction caused investors to breathe a sigh of relief and generated a rally towards the weekend. Phew!!! Glad that's over! Well sorry. Unfortunately it's not. It's just starting. I'm not interested in one auction and how well bid it is. I'm interested in the long term trend, and in this case the trend is becomming your friend.....if you're bearish on long term Treasuries. As my friends at Strategas say regarding long term U.S. bonds, "It's hard to quadruple the supply of anything and not have the price go down". Amen.

You see, there seemed to be a bit of a shift last week. The Fed came out and said that it was, once again, ready to buy long term Treasuries outright to try and stem the rise in yields that seems inevitable. But this time around, rather than rally the market, traders ignored the Fed, looked at the fundmentals, and drove yields higher (remember, price moves in the inverse direction as yield), signalling that the "bond market vigilantes" (a term used for bond traders who keep the market honest, despite what the Government might want rates to do) may be back. 10-year yields rose hard, breaking through initial and trend resisitance on the charts on consecutive days before falling back on Friday. 30-year yields have broken through resistance as well.

The moral of this story? As long as Washington insists that the cure for private sector overleverage is public sector overleverage, interest rates are heading higher and the dollar is heading lower. It's as simple as that. We are currently not atacking the root casue of the main problem hanging over our economy. We're simply pushing the solution out. As a result, we're looking at an anemic economic recovery as we sap the private sector to pay for public sector largess. It looks like bond investors are starting to figure this out. At some point, equity investors will too.

So how does one "play" this situation? If you're in TBT, stay there. If it retreats a little after the recent gains, buy more. If you're not in, get in. As we issue more and more debt, potential buyers of said debt (read China) will demand higher rates to compensate. This is the way it has worked in the past and this is the way it'll work in the future.

If you're in GLD stay in. You'll hear a lot of folks with a lot of varying opinions on gold, but use your head, look long term, and be logical. The dollar looks iffy due to our large and growing debt issue. China is beginning to argue for using something other than the dollar as the global reserve currency. China and Brazil just announced a trade pact in which they will pay for goods in local currency vs. the dollar. This is not the last you'll hear of this and it argues for being short the USD and long of gold.

Fundamentals argue for owning "stuff" vs. fiat currencies (especially ones who's debt loads look precarious) and gold is some of the "stuff" that folks should want to own. China sure does. They've increased their holdings of the shiny stuff by 70% since '03 and have been vocal about doubling their horde as a percentage of reserves going forward. If you don't own gold you might get a chance to move in a little lower as it consolidates the recent gains, but look to get in on dips. A upside break through $1003 gets us to $1300 on the charts, so I'd be keeping some powder dry to buy the breakout as well.

What does this mean for the equity markets? They sure have been hanging in there of late as more "green shoots" have emerged for the economy. Last night, Chineese manufacturing data came out and showed further expansion, allowing for more hope that a global recovery has begun. I'm not going to argue with that. It was the premise behind the bullish call I made in March. However, I continue to be concerned about the pace of recovery vs. expectations, and I'm wondering what earnings growth is going to look like going forward as a result.

This week may well be very interesting as we're approaching a test in the Dow Theory (in which one needs to see both the Industrials average - the makers of things - and the Transport average - the movers of things - moving in the same direction with the same conviction). The Industrials are looking like they want to test the highs while the Transports still have a bit to go before getting there. If both the Industrials and the Transports can break to new highs, we might very well be off to the races on another leg up. If the Transports don't "confirm" a break to new highs in the Industrials by hitting a new high itself, this would be a bearish situation. Only time will tell, but with bonds (which have been leading stocks in term of direction) not behaving well, I've got my eyes peeled!

Talk to you on Friday!

TRB