Wheeee! We Go Down The Bowl Last!

This is amusing to wake up to on a Monday morning….

The strengthening U.S. economy is proving no deterrent to the biggest rally in Treasuries since 2008, and America’s largest bank says it may get even better for bond investors.

Uh huh.  It’s called “fear” and it’s been driving money into the US and, specifically, into Treasuries.  It’s rather obvious with just a cursory look at the FX and Treasury markets.

The rally in Treasuries accelerated since October even as reports showed improvements in everything from consumer confidence to jobless claims to manufacturing.

Uh, no.  The rally accelerated since October since the threat of a Euro zone blowup has gone sky-high.  Money goes somewhere and the “somewhere” is here, at least for now.

The problem with this fear trade is this — if those fears become realized then the so-called “money” evaporates.

Huh, you say?  Yes, I said evaporates.

Remember folks, “money” comes into existence because someone pledges some sort of collateral for the debt that is on the other side of the ledger.  It’s a balance sheet and, as the name implies, always balances.

So let’s ask the question: What happens when there’s no more collateral?

That’s what happened, basically, in 2007 and 08.  The system ran out of people willing to pledge collateral because it had already all been pledged!  The “last and biggest” was in residential real estate, which is a mighty big asset base.  When that was all pledged (among those willing and able to pledge it) the monster started feeding on its own blood and the dollar went up while all those leveraged “asset” prices went down.

Now you’re seeing the same thing in Europe, and people are trying to flee here.  But US Treasuries with duration risk are pretty damn dangerous for the same reason — all lending to a sovereign government is both risky and uncollateralized, as it rests on nothing more than the government’s promise to tax the citizens tomorrow to pay that debt.  That premise, in turn, rests on people being willing to labor tomorrow for money they don’t get to keep as it was already spent!

Well, would you lend to someone making that promise but is already running a 43% deficit to received tax revenues when one looks at the total budget?

I sure as hell wouldn’t.

So for now we look like the best house in a crap neighborhood.  But in fact it’s all crap.  The question that remains is when we’re going to stop being stupid and have the government stop spending more than we make.  The answer is “not tomorrow, and not today.”

This of course leads to the next inconvenient question, which is “how rich are levered assets of all sorts — which means anything supported by a debt directly or indirectly in the market” against fundamental value if and when all of that debt — and the money issued against it — disappears?

The answer is not pleasant to contemplate.

Consider things thought of as “unlevered” such as physical gold.  Of course the problem is that gold is bought and sold using leverage every day on the futures market, at various leverage ratios from 2:1 for those investing in ETFs on margin to 10:1 or so for those using futures.  Remove all that leverage and the price could easily collapse by 90% in nominal terms!

Look at oil.  Same deal due to the same markets.  Stocks?  Same issue; not due to ordinary margin loans but effectively-uncollateralized gambling by HFT robots and futures markets.   Equities are “somewhat” better in that they are at the core supported by dividends — the return of actual capital from operations — but hose dividends rely on a levered free cash flow through the economy to remain payable.  Get rid of all of that and what dividends get paid and where is fundamental value?  Hint: S&P 300 is not unreasonable.

Housing?  What’s the down payment required nowdays?  Have we even gotten back to 20% down requirements?  Well, if we were, then it could be argued that a house is 5x overvalued!  But we’re not, of course.  Now I suspect that even in the worst of times we won’t get to 100% cash buys on houses only, although I can make a cogent market and economic stability argument that we should.

Therefore, expecting another 80% collapse in house prices is probably unrealistic.  But a 50% one?  Entirely possible and reasonable.

I find it amusing that people think this sort of outcome “can’t” or “won’t” happen.  It most-certainly can and likely will.  It has before and there’s no particular reason to believe it won’t this time around.  Indeed, what we continually see through our so-called “leadership” is a refusal to accept fundamental mathematics — specifically, that their overspending has created a debt-fueled overhang that cannot by sustained indefinitely.

Europe has done nothing to solve the essential problem — the political promise of services that cannot be funded with current tax revenues, and the inescapable reality that this must eventually end.  When it does the multiplication effect that this overspending has had on prices and output in the Continent will reverse.  That in turn will force GDP down to where it is supported by actual economic surplus.  Margins, being levered against cash flow, will contract dramatically and as Larry Kudlow loves to say “profits are the mother’s milk of stocks.”

Well Larry, in this case mommy sucked down a drink full of arsenic, the milk is poisonous, and mommy is writhing on the floor in agony as she draws her last breath.


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