There's a storm coming – but there's no reason all investors should suffer...
MOST PEOPLE misunderstand two things about the current financial situation in the US, writes Porter Stansberry in the Daily Wealth.
First, the US government's official debt burden might not yet have reached the "red line" of imminent default. But our entire economy's enormous debt burden makes it nearly certain we will default on our federal debt and many of our private debts, too.
The US is the world's largest debtor. As a whole, Americans owe a total of nearly $56 trillion (almost 400% of GDP). That's federal, state, municipal, corporate, and private (mortgages and student loans) debts. The debt service on our total obligation is $3.6 trillion a year.
It's hard to put that number into context because it's so large. Think about it this way: It's roughly the same amount of money as the federal government's entire budget.
To the extent our debts fueled past consumption (homes, cars, credit cards, health care, etc.), they are unlikely to spur future economic growth. That's not to mention a considerable portion of the debt belongs to foreign investors, folks who are typically more interested in building their next factory in Bangladesh than in Bangor.
When you combine this "debt tax" – aka interest – with the size of our actual tax burden (about $4.4 trillion when you combine federal taxes with state and local taxes), you can see why our economy is struggling.
We're spending half our annual GDP on taxes and interest.
Imagine if you had to spend half your family's income on taxes and interest. How would you rate your credit risk? What's the likelihood of default in that scenario?
More important, given our current federal deficits and the looming entitlement crisis we face (total unfunded future liabilities in excess of $100 trillion)... how is it possible to expect Americans will be able to afford to pay more taxes?
What would happen to our budget if interest rates rise because of inflation, which seems inevitable?
We don't think many Americans – even sophisticated investors – have considered these numbers. Our foreign creditors will realize they have no chance of being repaid in sound money. Americans simply cannot afford debt service, never mind principal repayment. There are signs they already recognize this...
Mainstream economists have long scoffed at the possibility that our foreign creditors might stop funding our existing debts at an interest rate we can afford. When you pose the question about our poor credit, they tell you our trading partners can do nothing about the Dollar. If they want to sell goods to Americans, they have to accept our Dollars. As Nixon's Treasury Secretary John Connally said, "It's our Dollar. But it's their problem."
For years, that was true. But it's changing.
Increasingly, US trading partners are taking our Dollars and – instead of recycling them back into Treasury bonds – they're Buying Gold and strategic commodities, like oil, copper, and steel. That's why prices for these commodities have soared.
That's obvious to most folks. What isn't so obvious is what it means for the bond market...
For the last nine months, the Federal Reserve has been purchasing 70% of all the debt issued by the US Treasury. What happens when the Fed stops buying? With 70% less demand for Treasurys, we expect prices to fall. Benchmark interest rates will rise.
Bill Gross, who runs the world's largest bond fund, agrees... which is why he's shorting US government debt.
Higher benchmark interest rates – perhaps sharply higher – should cause the US Dollar to strengthen against foreign currencies (like the Euro) and against commodities. It should also cause most US stocks to fall.
Over the long term, the average real rate of interest on US sovereign debt has been around 2% a year. The latest Producer Price Index (which we believe is more reliable than the Consumer Price Index) shows price inflation is currently 6.8% annually. Add the 2% real return we believe investors expect, and you get 10-year Treasury bonds yielding 8.8%.
Currently, those bonds yield only about 3%.
This implies a huge collapse of bond prices – a collapse of more than 50%.
A collapse of that magnitude would completely wipe out the stock market. It would be a massacre.
No one is expecting any of this. Everyone believes something like this could never happen. Yet this rise in interest rates would only carry us to the average return bond investors have earned over the last several decades. It doesn't even consider the kind of panic selling that would ensue.
In truth, rates might go considerably higher than this for one fundamental reason. If the bond market crashes, investors would begin doubting America's ability to finance its debts, never mind trying to repay them. As rates rise, the cost of maintaining our debts would grow substantially – perhaps doubling.
Keep in mind, the US Treasury currently pays only 1.4% annually to borrow $14 trillion. Yes, 10-year Treasurys currently yield around 3%. But because the Treasury has issued so much more short-term debt than long-term debt, US borrowing costs are lower.
No, all our debts wouldn't "reset" to higher rates overnight. But the losses in the bond market, the losses in the stock market, and the resulting decline in business activity would cause a lot of our creditors to worry about our ability to afford higher interest payments.
Think about it this way: By the end of 2012, our national debt will likely exceed $17 trillion. Let's assume our average interest increases to 4.4% – half the rate we believe investors will eventually demand. That works out to an annual interest expense of almost $750 billion. That's more than we spend on defense or Social Security. Interest expenses would leave the government spending almost $0.25 of every Dollar on interest payments.
Does that sound wise or reasonable to you? Given these expenses, some of our creditors would become reluctant to "roll" our debt into the future by offering new loans. This could cause a serious problem for the US Treasury.
Portugal's government recently had too much short-term debt coming due and not enough lenders were willing to extend these loans at affordable rates. It suffered a debt default. The country required a bailout by the European Central Bank (ECB). Lots of economists criticized Portugal's borrowing strategy because much of its debts were short-term.
Apparently, these folks haven't bothered looking at the US Treasury's debt-maturity curve. We have. The numbers are so shocking, we expect most of our subscribers simply won't believe us.
You can read all of the numbers for yourself, if you'd like. The Bureau of the Public Debt includes them in its Financial Audit, which you can read here.
Feel free to read all 35 pages... Or focus on just one piece of data. It's all you really need to know: 61% of all the marketable Treasury debt held by the public will mature within four years.
Thus, over the next four years, the US Treasury must either repay or refinance more than $1 trillion in existing debt each year – not to mention additional deficit spending of at least $1.5 trillion. For us to avoid a default, the US Treasury may have to borrow or refinance as much as $10 trillion in the next four years.
That would double the amount of US Treasury bonds currently trading in the world's markets.
Think about that for a minute. Then consider the decades-low yields in the Treasury market today, which would surely rise to accommodate this enormous increase in supply.
Now, try to arrive at any sort of scenario that ends well for today's US Treasury bond market investors. We can't... We don't know exactly what the end game will look like or exactly when the bond market will crash. But we know it is coming. We know it can't be avoided. And we know many investors will suffer catastrophic losses.
Given these risks, the Federal Reserve cannot allow the Treasury's borrowing costs to increase. It cannot allow the Dollar to strengthen. It cannot allow the stock market to fall or business activity to slow...
That's why we are 100% certain the Fed's promise to stop printing money and buying Treasury bonds on June 30 is a lie.
Even though we know Bernanke will have to turn back on the printing presses sooner or later, we have no doubt the market will react strongly to the presses' temporary stop. Expect big moves: falling commodities, a rising Dollar, and even falling stock prices.
We have been warning our readers since the spring of 2010 that the stock market was no longer broadly attractive. Since then, valuations have only gotten more extreme. A big correction is overdue. We will likely get that correction this summer.
That means for the risk-averse investor, the best advice I can possibly give right now is to seek safety. Seek it in a diversified portfolio of cash, gold, silver, and a "core" position of income-producing blue-chip stocks bought at cheap prices.
There's a storm coming... but there's no reason you should suffer, as the vast majority of Americans will.
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