Sunspot Baby, She Sure Was a Real Good Time

She packed up her bags and she took off down the road

Left me here stranded with the bills she owed

She gave me a false address

Took off with my American Express

Sunspot Baby

She sure had me way outguessed

"Sunspot Baby" by Bob Seger Bob Seger - Sunspot Baby

OK, lets say that last year you made $107,500, but you spent $328,400, for a net deficit of $220,900. Not a bad life style, hey. You've tapped out all the equity in your home, and have ran your credit card balances to the point of no return, but you've had a good time spending that extra $220,000. Now what? 2010 rolls around and you go to your friendly neighborhood banker and explain that while it may look like you are a prolific spender, you're still gamely employed and will probably only need to borrow about $250,000 this year. Borrow, he says, you still haven't paid back any of last years borrowings! All right, enough, this is an absurd scenario...too bad its true.

 The Monthly Treasury Statement (MTS) just came out and announced that the February budget deficit was $220.9 billion, after receipts (mostly tax revenue) of just $107.5 billion and outlays of $328.4 billion for the month. This is a record! That's right in the month of February the Government was spending about three times what they were taking in. Fortunately for us we have a very friendly banker, the Federal Reserve. Could you imagine how crazy this would be if we were talking about real money (like gold) instead of those funny little pieces of paper that the Treasury prints all day long. What makes this even more absurd is that generally when you are spending 3x more than you earn you would expect to have to pay more to fund your lifestyle. Not so for the good old U.S. of A.

Period

Receipts

Outlays

Deficit/Surplus (-)

Jan-09	r226,090	r289,548	r63,457
Feb-09	r87,312	r281,171	r193,859
Mar-09	r128,926	r320,514	r191,589
Apr-09	r266,206	r287,113	r20,907
May-09	r117,217	r306,868	r189,651
Jun-09	r215,340	r309,671	r94,332
Jul-09	r151,481	r332,160	r180,680
Aug-09	r145,529	r249,084	r103,555
Sep-09	r218,880	r264,088	r45,207
Oct-09	r135,294	r311,657	r176,363
Nov-09	r133,564	r253,851	r120,287
Dec-09	218,919	r310,328	r91,410
Jan-10	r205,240	r247,874	42,634
Feb-10	107,521	328,429	220,909

 The interest paid on the debt was a mere $16.9 billion. The reason for this as TreasuryDirect points out, in February the interest on public marketable debt (actual cash outlays), which as of Monday stood at $8.061 trillion (trillion with a T), hit an all time low of 2.548%. How is it possible that unprecedented debt accumulation can result in ever declining interest rates? One answer: the Federal Reserve, which through complete domination of the entire capital market has been able to turn logic upside down. In a normal world, the more money you borrow, the greater the associated risk, and the greater the interest payments on this debt. Not in America though. So, can we assume that the Fed can forever keep rates on debt at record low levels? No. Which begs the question: what happens when interest rates do finally start going up?

 Now we know we are in a recession (great recession) and our income levels are down, but expenditures have exploded, and they've exploded due to spending, not the interest paid on that spending. The bulk of the spending was for entitlement programs at $160 billion. Again, our measly little $107.5 billion of income doesn't even cover entitlements. But here's where the debt comes in. The debt ceiling was just lifted to $14.3 trillion, but will probably be broken by mid-year. If we assume total debt of $14.3 trillion in less than a year, of which about $10 trillion is marketable debt (up from the current $8.06 trillion), then at an interest rate of 2.5%, interest on the debt would be $250 billion (about $21 billion per month). If the U.S. governments borrowing costs were to rise to say 4%, then interest on the debt would be $400 billion. As recently as September 2007 the Fed's borrowing costs were 5%, and they plunged to 2.5% in just over a year.

 For all of those out there worried that all this debt will lead to higher interest rates, you are probably right, but not any time soon. Don't forget that the Fed is very cognizant of what higher interest rates would do to the deficit, and they are in no hurry to see that deficit balloon any faster than it already is. So expect the Fed to keep rates low for an "extended period", and if they have to, they can always roll out the "quantitative easing" apparatus. Until the Fed sees some significant growth in tax receipts (Income), or some significant cuts in spending (not likely), don't expect them to do anything that would cause the rates the government has to borrow at to go up. Add to that todays dovish appointment of the very gellin' (Dr. Scholl's - Gellin' Wedding) Janet Yellen as the new vice chairman of the Federal Reserve, and you have an interest rate environment that is soooo gellin'. 

The Fed does not have complete control over rates though, they still have to sell those bonds to someone. That someone of course (say China) may start to demand a higher rate to compensate for the higher risk. But of course China enjoys the fact that they can keep the value of the Yuan artificially low to stimulate their exports, and they enjoy having us by the short hairs, so they are in no hurry to tip over the apple cart. Oh what tangled webs we weave. If everyone plays nice we have nothing to worry about! 

Investment Considerations:

We have been at maximum weight in TIPS (Treasury Inflation Protected securities) since September of 2009, but lately our indicators are pointing towards a more neutral stance. Meaning that Mr. Market is telling us that inflation is not a near-term risk.  Meanwhile our WIPS (International Govt. Inflation Protected securities) have been in neutral territory since mid January. While higher rates and inflation are a very real risk, it just doesn't appear to be an immediate threat. So join the Sunspot Baby and do a little gellin' this weekend. "She left me here stranded like a dog out in the yard. Charged up a fortune on my credit card. She used my address and my name, man that was sure unkind. Sunspot Baby, she sure was a real good time." 

Be careful out there,

Chris Wiles

www.rockhavencapital.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.