By
The
Inflation Trader
:
Unless Monday's unseasonably-warm temperatures in the New York
area (through some metaphysical conservation-of-energy mechanism)
means that Hell is freezing over, we are a long way from resolution
on the fiscal cliff discussions.
The Republicans countered President Obama's
proposal
for a $1.6 trillion tax hike with their own plan that would cut the
cumulative deficit (according to static scoring, as all of these
proposals are) by $2.2 trillion through a combination of closing
special interest loopholes, introducing deduction caps on high
earners, increasing the Medicare eligibility age, cutting some
discretionary spending, and using chained CPI as the Social
Security escalator in order to slow the growth of benefits. After
having previously lambasted the Republicans for not offering
specifics, the White House Monday labeled the proposal "nothing
new," apparently without irony.
To be fair, the Republicans had called the President's proposal
a "la-la land offer." So you can see, we are obviously very close
to a deal and a smiling, hand-shaking, giddy signing ceremony in
the Rose Garden.
All of this is sheer madness. These hikes and cuts are measured
over the projection horizon, so we're arguing about cutting perhaps
20% per year from the current trillion-dollar deficits. Good
heavens, it's a good thing we're not trying to do something
radical, like balance the budget. The combination of the national
debt and the Social Security and Medicare liabilities add up to
over $1.1million per taxpayer (
Source:
www.usdebtclock.org
), and the debate is over cutting around $20,000 per taxpayer over
the next decade. Don't strain yourselves, fellows.
It's incredible that some of these things are even subject to
argument. The Medicare eligibility age will eventually be
effectively infinity, because the program is not viable on this
planet with health care such as we have come to expect, and since
the liability is in real terms (units of healthcare, not of
dollars) we can't inflate our way out of it. So gradually moving
the eligibility age a whole lot higher is something that we simply
will have to do. Why not now?
People who say that cutting the deficit by $2.2 trillion over
7-10 years is hard to do have not actually tried it. It is actually
pretty easy to get the budget back to some semblance of balance, as
long as you don't have to run for re-election or if you consider
the future of the country to be more important than winning another
term (and you know, there's even a chance your constituents may
reward that bold sacrifice!). All that you have to do is to reverse
most of the things we've done to the budget over the last decade
and you're close - of course, the interest costs now are a lot
higher, and will only climb in the future. But if you put
entitlement reform on the table, it gets downright easy…again, if
you don't have to run for re-election.
Now, that interest portion of the deficit is somewhat scary. The
chart below comes from Bloomberg, and it's one of my favorite
Bloomberg functions ((DDIS)). It shows the debt maturity
distribution of U.S. Treasuries, and shows the interest and
principal amounts currently scheduled.
It appears as if the interest costs (right column) max out at
$196bln in 2013 and then decline, but keep in mind that these
numbers ignore the fact that debt will be rolled when it matures.
The $196bln is something closer to the baseline expectation, in the
event that the Fed keeps interest rates anchored pretty near zero.
It may be disturbing to note that the Treasury next year needs to
roll $1.26 trillion in maturing securities, in addition to the $1
trillion of new money they need to raise due to the deficit; in
2014 the problem will start to grow even scarier as all of the
5-year issuance from 2009 starts to come due, along with all of the
debt that has been rolled in the last couple of years. If you want
to point to a come-to-Jesus moment in the bond market, it is likely
to be in 2014 when this fact intersects with the expectation of the
end of QE. It's one thing to sell $2.26 trillion in Treasury
securities if the Fed is committed to buying $1 trillion of them.
It's a little harder when they're not, or if they are (as they
claim they can) actually trying to sell some Treasuries from their
own vaults. Good luck.
That's why I don't think we ought to be arguing over $200bln per
year in the fiscal cliff. The problem is already much larger than
that.
Now, that presumes that QE actually ends sometime in 2013. Some
Fed officials have recently made noises to suggest that there is no
reason that QE needs to end any time soon, and that the Fed is
"nowhere near" the limit of what it can do. The problem is that
2014 will force a very serious choice on the Fed, because I think
inflation is going to continue to rise throughout next year (our
point forecast for core inflation is about 2.8% for 2013, but with
all the tails to the upside), while I seriously doubt that
Unemployment will get below 7%. And, as just noted, the market
reality is that without Fed buying, the Treasury is going to have a
devil of a time placing its debt in 2014 without higher yields (as
an aside, I also suspect all dollar swap spreads will be negative
in the next few years).
I'm not the only one who thinks that inflation is likely to be
rising. While the nominal interest rate debacle is, in my opinion,
not likely to hit us until 2014, rising inflation is happening
today and the expectation of a continuation of that trend is being
reflected in inflation swap rates. The chart below (
Source: Bloomberg
) shows that 10-year inflation swap rates are again up around
2.75%.
Now, if inflation expectations are rising but the Fed is going
to fix nominal 10-year rates at 1.60%-1.80% where they are now,
then the scary result is that TIPS yields, already ridiculously
low, could go further. I am not bullish on TIPS, because as a rule
I won't buy something that is rich on the expectation that it might
get richer. That way lies madness, since when the thing you bought
goes down you have no plausible excuse. Moreover, speaking for
myself, I know that I would be unable to maintain a position that I
knew to be fundamentally mispriced the wrong way. But if 10-year
inflation expectations went to, say, 3.6% and 10-year nominal
yields were fixed at 1.6%, real yields would be forced to -2.00%.
This is the reason I won't short TIPS in the current environment,
although I view them as overvalued.
What article would be complete without news from Europe? Monday
Greece offered to pay up to €10bln to buy back their own bonds,
with bids due Friday. Completion of this buyback is a precondition
to Greece's receiving the next tranche of the bailout, but it will
be challenging if they refuse to pay market prices (as the Euro
finance minister communiqué released last week suggested, since it
limited the prices paid to those prevailing on November 23rd). It
still is a philosophical step forward, since at least it serves to
recognize the unrealized gains that Greece effectively has when its
liabilities are priced where they are now. This is, after all,
essentially the same thing that happens in a default: in that case,
Greece would offer to pay 35 cents on the dollar for all of its
debt. In this case, they're trying to "default" on just enough of
the private debt so that the public debt can be carried at par for
a while and maybe, someday, be paid off at par.
I just wonder if they can make it to "someday."
See also
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on seekingalpha.com