The Farce of the US Government ‘Shutdown’

Will 2013 go down as the year we saw a definitive change in the fortunes of the great American Empire? That’s the question we’ll ponder today – and its effect on Australia – as news over the US budget impasse looks set to dominate the week’s events.

Markets rallied on Friday on hopes that Republicans and Democrats would come to some kind of agreement over the US government shutdown and the looming debt ceiling issue. But on Sunday in the US, senior Republican and House Speaker John Boehner said that it was time to ‘stand and fight‘.

Them sounds like fight’n words…

S&P 500 futures consequently fell, and so far this morning our market is trading in a more subdued manner too.

The main issue here is that the US is living well beyond its means. There are some in the Republican Party who recognise this fact and want to extract major budget concessions before resolving the government shutdown and approving another increase in the debt ceiling.

The whole ‘shutdown’ thing is a bit of a farce though. The Financial Times reported today that the Pentagon ordered most of its 350,000 civilian employees back to work.  And the remaining 450,000 on ‘furlough’ will receive full pay during the remainder of the shutdown, thanks to a weekend Congressional vote.

We don’t understand the US voting process. But it seems strange that Congress can cause a government shutdown and then turn around and agree to pay those that they previously agreed to furlough because of budget constraints. The logic of politics…

The logic of economics is a little clearer though. The simple logic here is that the US consumes far more than it produces. It relies on foreigners to finance the difference (with their excess production). But since the 2008 credit crisis, when the US government had to prop up the system with $1 trillion-plus government deficits, foreigners haven’t had the appetite.

That’s why the Fed had to come in with QE. If it were left to the market to clear the massive new supply of government bonds, US Treasury yields would have increased sharply, causing a deep and prolonged recession.

Initially the market did absorb the increase in Treasuries as a ‘safe-haven’ investment. But by 2011 the Federal Reserve announced the purchase of around US$600 billion in Treasuries to ensure that long term borrowing rates remained low.

The lack of foreign appetite for US debt also explains why Bernanke increased the QE program up to US$85 billion per month in late 2012, even though it appeared the US economy was gathering strength at the time.

But the strength or otherwise of the US economy had nothing to do with it. The Federal Reserve increased its asset purchase program because US creditors were no longer willing to absorb the huge annual increase in Treasury debt.

As we pointed out to readers of Sound Money. Sound Investments last week, in the 12 months to July foreigners reduced their purchases of US Treasury bonds by an amazing 87%! That is, in the 12 months to July 2012, foreigners (both the private sector and central banks) bought US$560.5 billion in Treasury bonds…but 12 months later purchases fell to just US$74.8 billion.

The decline in purchases would not have gone unnoticed by the US Treasury. By late 2012, the decline might have even become worrying, leading then to have a word to the Fed.

Don’t forget QE3 was initially a plan to buy US$40 billion per month in mortgage backed securities. The Fed announced it in September 2012. Then, in December, the Fed announced it would increase the program by buying US Treasuries at the rate of US$45 billion per month.

The increase in Treasury purchases was apparently about improving the economy and unemployment, but more than likely it was about picking up the slack from diminished foreign appetite.

So now the Fed (at US$540 billion per annum) is the main buyer of its government’s debt issuance. That’s not good, and is a sure sign of a decline of Empire.

If foreign investors have deserted the Treasury market, you may be wondering why the US dollar is not weaker. Well, so far, foreigners have just shifted their assets from long term debt securities to short term cash type deposits. We don’t really know what to make of it, other than to say cash is less risky than a highly inflated bond market where a central bank is the primary buyer.

All those countries with trillions or hundreds of billions of US government debt in their coffers must be wondering just how they are ever going to get out of it. Well, they’re not going to. If you’re a large holder, it’s not a market you can get out of.

The first step though is to stop buying more. You’re now seeing the start of that process. China and the oil exporters are down from their peak holdings of Treasuries, while the Japanese have been big buyers recently. It makes us wonder whether the US Treasury advised Japanese Prime Minister Abe on Japan’s latest monetary experiment, with the intention of getting Japan to help finance a few more years at least of US government spending. It certainly looks that way…and Japan had nothing to lose.

With economic decline comes a decline in international influence. You’re seeing that quite clearly in the Middle East now. The US has long had a presence in the region due to its massive oil reserves and the obvious strategic importance of oil.

But US policy in the region is a shambles. In Egypt, Libya and now Syria the US has not handled the situation well. This is emboldening traditional rivals like Russia and Iran. And sectarian violence continues to plague Iraq. There are fears that it is again on the brink of civil war.

If the US begins to lose control of the Middle East, it will be just another signal of a declining empire.

In order to maintain control though, they need to continue spending large amounts on a military presence. When you rely on foreigners to provide you with credit to do that though, it becomes a difficult task when your foreign creditors pull back.

We’re not sure whether the hard core Republicans actually understand this, or if they’re just trying to use the debt ceiling and shutdown to achieve their own short term political aims. But it is clear that Obama doesn’t understand (or doesn’t care) about the US’ looming financing difficulties one little bit. It’s a spend, spend, spend administration and damn the consequences.

Well, at some point, there will be consequences. And we think that point is approaching quicker than most people realise.

So what will the consequences be for Australia? We really don’t know. If the credit of the world’s most powerful nation comes under scrutiny, we would guess the result would be a lot of confusion and volatility.

Countries like Australia, who also rely on foreigners to finance our deficits, might come under particular pressure as foreign capital becomes nervous. That last happened during the height of the credit crisis.

Only this time the government won’t have as many levers to pull to insulate us from the volatility. And China won’t be able to pull out another massive stimulus to boost our national income. In short, when the next crisis hits we’ll be defending ourselves from a position of relative weakness.

How this all plays out is anyone’s guess, but it is becoming increasingly clear that the age of American empire is over. The transition will take years still to play out, but they will be increasingly uncertain years.

Which is the problem with the stock market and asset prices in general now – especially Aussie residential property. These assets are pricing in a very certain future. Certainty of income and capital growth and certainty of economic stability to provide this growth. But more than at any time in the past few years, the future is murky and fraught with danger.

After all, the world’s biggest spendthrift doesn’t get its credit card cancelled every day. And while it might be happening in slow motion, the data tells you that is exactly what is happening.


Greg Canavan+
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From the Archives…

Inflation: Australian Savers, Don’t Get Comfortable
4-10-2013 – Vern Gowdie

Punch Drunk on Gold’s Volatility
3-10-2013 – Nick Hubble

How Aussie Property Could Turn on Investors Very Badly
2-10-2013 – Nick Hubble

US Government Shutdown Threatens Panda-monium
1-10-2013 – Nick Hubble

SMSFs Enter the Great Australian Property Debate
30-09-2013 – Nick Hubble

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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