Government Bonds: The Next Financial Disaster

In the last Market Watch article we discussed the possibility of a bond market crash. Since the article was published in June, yields on bonds have zoomed. Bond prices have dropped dramatically. Government bonds are decreasing in value because the public is unwilling to take interest payments of 1-1/2 to 2% annually for the risk of holding government debt. Bond buyers are aware of the fact that U. S. spending is much more than tax revenues. They see the market can no longer sustain such borrowing to support government spending.

The Fed has controlled interest rates as long as they could; now the law of supply and demand is taking over the bond market. Of all federal government annual expenditures, 43% must be borrowed. There is no way out of the dilemma without drastic cuts in government spending. Since the entire 43% deficit goes to welfare recipients, politicians are unwilling to cut the deficit and risk the loss of votes of the 40% of our population that is receiving welfare benefits.

Politicians want us to believe a “modest” tax increase is needed to close the gap between government expenditures and the income taxes laid upon the people. Looking at the chart, it’s difficult to see how much more tax revenue can be developed from the top 10% of wage earners. The top 10% has increased total income taxes paid from 55% of all income taxes in 1986, to 71% of all taxes paid today. Amazing! Incredible! Robbery!

% Of Total Income Taxes Paid By:
Year	Top 10% of Wage Earners	Bottom 90% of Wage Earners
1986	55%	45%
2011	71%	29%

Question: Why not move the amount paid by the top 10% of taxpayers to 80%?
Answer: Capital always flees from confiscatory taxation, taking jobs and investment with it. Current examples: Detroit, New York, California and Illinois. Furthermore, and unfortunately, an increase to 80% of all income taxes, paid by the top 10% of taxpayers, would provide only a modest dent in the government’s deficit.

Look at three “leadership states”: New York, Illinois, and California, representing almost 25% of our population. They are all broke. There are more people on welfare than there are people working. Taxes have become so great that the most productive, and wealthiest, citizens have moved to other states. What is happening to those states is the same thing that has happened to the city of Detroit. They are insolvent. They are insolvent because high taxes have driven management and money out of their states.

It is difficult for investors to navigate their way through what is happening and will continue to happen in the next several years. The stock market is way over priced. If the Dow were selling at average values, the market would be at 9000 points, not the 14,800 points of today. The stock market’s excessive values are a result of government making new money of $85 billion a month available to the “too large to fail” banks. This new money is made out of nothing but paper, without a lick of sweat or hard work involved. Easy money ALWAYS finds its way into the hands of speculators first, whose trading activities keep the stock markets at unrealistic levels …… until the market crashes and reminds us of what the words “average values” mean.

Interest rates have increased more than a point since April. The mechanics of the existing, and continuing, bond market crash will have a huge effect upon the stock market, too. Consequently, our best bet for investing money over the next several years might be to retain strong cash positions, and have a healthy amount of hard assets like real estate, gold and silver. While we cannot guess future values, we do know that in 25 years our dollars will be worth much less than today, and real estate, gold, silver and other hard assets will be worth far more than today. At our increasing pace of government spending, and commensurate printing of millions of dollars every day to pay the bills, we’ll experience much more inflation in the next 25 years than we have in the past.

Question: If we don’t own many bonds, why should an investor be concerned?
Answer: Total U. S. outstanding debts are $53 trillion. Federal government debt alone represents $17 trillion. At last year’s interest rates, the government paid almost $400 billion a year in interest costs. Reasonable interest rates of 6%, which is where the market is heading, would increase the cost of government borrowing to interest payments in excess of $1 trillion annually. The $600 billion increase in federal government interest costs would take a currently bloated government budget and make it unfathomable. Increasing government interest costs also means increasing borrowing costs for all of the rest of us. Those increasing interest burdens will lower corporate earnings. Lower corporate earnings mean falling stock markets. The interest burden on non-U. S. Government debt would increase an additional $1.5 trillion. Added to the increased federal government financing burden of $600 billion, the GDP would theoretically have to absorb additional interest costs of $2 trillion annually. Impossible in a $15 trillion GDP, but that’s the direction in which we’re headed.

Question: Can’t the Fed just continue to make money until things smooth out?
Answer: Yes; however, a good deal of the banking industry’s capital is comprised of federal government debt. Banks make loans collateralized by that debt. As interest rates increase, bonds decrease in value, so the banking industry’s capital is shrinking. Banks must maintain ratios, legislated by law, of loans to their amount of capital. Banks will no longer be able to make loans if those ratios are violated. Outstanding loans will have to be called in so that the bank’s capital ratios are met. Leveraged businesses will be in trouble if their loans are suddenly liquidated and short-term borrowing ceases to be available. This has happened in every crisis the last 40 years, each and every one of which was caused by government overspending, borrowing, and legislation.

The public thinks that earnings move markets, but that’s not true. What moves the market is what people are willing to pay for those earnings. That is referred to as the price earnings ratio. The current price earnings ratio on the Standard and Poor Index of 500 stocks is almost twenty times earnings. Historical Standard and Poor price earnings ratios are 14 times earnings, so we are now 43% above the historical average. How much more are investors willing to pay for earnings that are headed south?

We have seen a huge deflation in the price of overvalued hard assets, the best example of which is real estate. Those markets are in the process of correcting their values to reasonable levels. This correction (deflation) in paper assets, like stocks and bonds, is only in the beginning stages. The “new money” put into the banking system of $1.2 trillion annually the last several years has “propped up” paper asset’s values. It’s acted like a subsidy, itself being a paper asset.

These are dangerous times in our economic history. The mathematical weight of our economic over-reach is upon us. Play it safe. Prepared investors will most easily be able to survive these uncertain and chaotic times with assets more durable than stocks and bonds.

Caveat Emptor.
George Rauch
September 6, 2013

....