Gagging on Debt

Finally some good news. Consumer confidence in the States is at its highest level in a year. The Conference Board reported that its index rose from 26.9 to 39.2. We have no idea what those numbers actually mean. But hey, if households are feeling better about the economy, that’s not a bad thing.

Of course feelings aren’t the most important thing in an economy. True, the “animal spirits” Keynes wrote about have to be out and about in an economy on the move. But facts matter too. And how you feel about the facts doesn’t change what they are.

Take the National Australia Bank. Yesterday the bank told investors its bad debt charges in the first half of the year had doubled to $1.8 billion. That bad debt charge was more than double the charge for the same period the year before. Your perception of the charge doesn’t matter. It is what it is.

The good news for NAB is that its Australian operations account for two-thirds of its profit. The bad news is that it may face more losses from its U.S. and European investments. It won’t be alone if that happens, of course. But we’re just saying that there are probably a lot more loan losses ahead for global banks this year and next.

That said, at least NAB is not the Bank of America (NYSE:BOA). BOA may need as much as US$70 billion in capital to plug what regulators are calling its “capital hole.” The results of the U.S. government’s stress tests of 19 big banks aren’t public yet. But the Wall Street Journal quoted “people close to the company” who said that the Feds have told BOA it needs a bigger cushion against future losses. Whether that means more asset sales or diluting existing shareholders with new equity we don’t yet know.

Where would the losses come from? Probably commercial real estate and, yet again, residential housing. We know you’re probably sick of hearing about it. But we just want to remind you that neither the banks nor the financial system are done taking the losses on the great property and housing binge of the last decade. The binge was huge. But the purge is coming.

Trying to prevent the economic gag reflex from kicking in is the U.S. Federal Reserve. The Fed meets on Wednesday and maybe they’ll do something worthwhile. Or maybe not. The Fed will be paying attention to the yields on government bonds. It’s been buying those bonds (or announcing its plans to do so) in an effort to bring down mortgage rates and other borrowing rates that are pegged to official yields.

But the bond market is not cooperating perfectly. When it’s cooperating at all, it’s doing so with maximum resistance. Ten-year yields on U.S. notes were back up over 3% in New York trading yesterday. We’ll see if the bond vigilantes have it in them to push the Fed on this. Rising ten-year yields will eventually push up mortgage rates, nullifying the Fed’s efforts to boost the housing market.

The trouble is, there’s just so much debt out there with more coming each day. The Treasury announced yesterday it would borrow US$361 billion in the second quarter. That’s double what it estimated it would need just three months ago. And usually the Treasury doesn’t have to borrow much in the April quarter because that’s when Americans pay taxes. For example, it borrowed just $15 billion the same time last year (did we just write ‘just $15 billion’?).

But the Fed needs $200 billion for its Supplementary Financing Program (to save the housing market). So the Treasury will be tapping the market for mo’ money. The previous record for borrowing in the April quarter was $60 billion. Treasury borrowed $481 billion in the January quarter and expects to borrow $515 billion in the July quarter.

One small piece of data worth watching is the quarterly refunding statement that the Treasury releases on Wednesday in the U.S. This refers to maturing debt which has to be refinanced, as opposed to the new debt issuance mentioned above. It matters because of the marketable U.S. debt outstanding, an increasing percentage of the total is composed of shorter-maturity bills and notes rather than 20-year or 30-year bonds. This is an example of the compression of time and expectations we wrote about yesterday, where inflation discourages long-term planning and investing).

It also makes rolling over U.S. debt an extremely interest rate sensitive exercise, which is why the Fed will be watching bond yields like a hawk (pardon the pun). If you wanted a gratuitous prediction, we’d say the Fed is going to have to step up its buying of Treasuries in the open market (continue monetising the debt) in order to keep rates low. It also has to placate larger creditors to the U.S. who are eager to unload their large holdings of U.S. debt on the Fed before that debt is devalued by more money printing (China).

What a weird status quo. On the one hand, it’s obvious, based on the government’s own stress tests (or at least the leaked results) that there are billions in loan losses ahead which must be offset by new capital raised from private investors. Private investors and sovereign wealth funds can choose to recapitalise banks…or loan money to cash-strapped governments in the U.K., the U.S. and elsewhere (there are big ‘capital holes’ in national government budgets as well). Or they can stockpile commodities and cash and gold.

So which will come first, a huge new wave of deflating credit-backed assets, or a huge new surge in quantitative easing measures that keeps rates down and asset prices from crashing but drives up the price of real goods? It’s pretty tough to say today.

Before we move on, thanks to everyone who signed up for our Twitter feed. You can still do so at As we suspected, it’s about as superficial and meaningless as modern communication gets. But if you’re one of those people who has always craved/begged/pleaded for a shorter version of the Markets and Money, this is it! Twitter updates can’t be any longer than 150 characters. This is forcing us into a haiku-style of financial reporting.

Or, if you prefer just a weekly summary of the week’s biggest DR stories, keep an eye on your inbox this weekend. An Elwood-based DR reader with a Diploma in Applied Finance and Investment from the Financial Services Institute of Australia has volunteered to put together a weekly digest. He thought it would be just the sort of time-saving piece that would fit with his busy schedule. So for the last month we’ve been testing the publication in-house. We’ll do it live this weekend on a trial basis and you can let us know what you think. It’s designed for those readers who want an edited summary of the week’s big stories all in one place.

Did you see the note about Antarctica in today’s Australian? In case you missed it, the sea ice around Antarctica is expanding, not contracting. “A study released last week by the British Antarctic Survey concluded that sea ice around Antarctica had been increasing at a rate of 100,000sqkm a decade since the 1970s. While the Antarctic Peninsula, which includes the Wilkins ice shelf and other parts of West Antarctica were experiencing warmer temperatures, ice had expanded in East Antarctica, which is four times the size of West Antarctica.”

Finally, check out the chart below from U.S. Goldcorp. Remember last week we mentioned that the world of government issued paper not backed by gold has been expanding in ever-widening circles for the last 100 years? The chart below shows just that, like a tide of paper money flowing into the world’s real economy leading to bubbles. And then the tide turns, leading to asset price crashes and soaring prices for precious metals as the bad investments from the boom are liquidated.

Source: U.S. Goldcorp

The chart specifically shows the Dow vs. Gold ratio going all the way back to the 19th century. What you can see is that large credit expansions lead to a high Dow/Gold ratio. The value of stocks relative to gold soars as all the funny money in the economy translates into new corporate earnings and inflated expectations of future corporate earnings (much higher P/E ratios).

The disarming thing about this chart is that it doesn’t look that far between a ratio of nine ounces to one and one to one. Oh, but it is. A one to one Dow/Gold ratio means Dow 5,000 and gold $5,000, or Dow 6,000 and gold $6,000. It’s also worth thinking about the extremes. Dow 4,000 and gold $4,000 is huge move for gold and a crash in the Dow. You could see this happening with another capital crisis in the financial sector.

But it’s also possible that the Fed and other central banks can pursue unorthodox policy measures like purchasing stocks with freshly printed money. This would support stock markets nominally, although in inflation adjusted terms it would be a bogus number. But psychologically, gold $9,000 might not be as startling if the Dow were at say, 18,000.

Yes yes. That sounds absurd. But we live in absurd world. People trade real goods which have tangible value for perfectly worthless pieces of paper. Anything is possible.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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6 Comments on "Gagging on Debt"

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Coffee Addict
The other news is that the “first wave” of the so called “swine flu” is a fizzer. Key observations: 1. Mortality outside of Mexico for the current sub-strain appear to be not much different to seasonal flu, that is very low. 2. Respiratory specialists in Mexico City report up to 240 likely deaths (read what the Mexican Doctor’s are blogging on the BBC site). But Mexico and Mexico City are big places. There are about 20m people in Greater Mexico City alone and if I assume a 40% exposure rate and a 1% mortality rate this would imply something in… Read more »
Greg Atkinson

CA…exactly. The reporting has been way over the top especially from what I have seen in the online Australian media. Blazing headlines like: Swine Flu Speads: Aussies Tested.

I think this from CNN says it all: “But even if there are swine-flu deaths outside Mexico — and medical experts say there very well may be — the virus would have a long way to go to match the roughly 36,000 deaths that seasonal influenza causes in the United States each year.”

Seen that in an Australia media report yet? Probably not.

“Nothing about swine flu seems thesis changing” * Jeff Kearns, “U.S. Stocks Fall as Swine Flu Drags Down Travel, Hotel Shares”,, April 27, 2009: Stocks battered by the swine flu outbreak may represent bargains for long-term investors, said JPMorgan Chase & Co.’s Chief U.S. Equity Strategist Thomas Lee. The decline in global equities following the outbreak of Severe Acute Respiratory Syndrome in February 2003 proved to be an “excellent” opportunity to pick up shares, Lee said. This is probably a similar situation, the New York-based strategist wrote in a research report today. “Nothing about swine flu seems thesis changing,”… Read more »
tom pson
Can I ask A Q to investors in D&D and ASI Looking at your investment Who’s made money? There is only one bit of honesty in these publications It is not the constant spruiking that helps It is the table of returns on actual investment at the time the investment was recommended the majority have turned out HORRIBLY WHY don’t Dan and Kris address this? YET this is the reality for people who follow your advice. The advertising is ENTIRELY misleading, geared to draw you in. The shame is that fundamentally I think, through the articles you post for everyone,… Read more »
tom: I subscribed to ASI a year ago, but didn’t do very well. I agree that ASI didn’t help so much. However it may be a bit better nowdays as they get their head around how small-caps work. See, it may not be ASI that is the problem so much, but small-caps and the market in general. Small-caps is a good place to be in a boom. Not in a bust. However…I do think that Dan’s articles in general have been very good. I’d say about 4 in 5 have been useful for me. I check the site every day,… Read more »
I’m an ASI subscriber, and I was lucky enough to only invest in about five of the recommendations, four of which are doing pretty good (and two are paying very nice dividends). I have no experience in the stock market, and I have learned heaps over the past year, about my own emotional reactions to the ups and downs most importantly. I’m especially glad personally that the one of of five that did so badly was a headliner for ASI, as I am much wiser for it than if everything I picked somehow turned to gold. Think for yourself, learn… Read more »
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