Month: October 2018

Brett Kavanaugh – considered to be the poorest Supreme Court Justice on the bench, has declined nearly $600,000 that was donated to him through a GoFundMe campaign amid a firestorm of sexual misconduct charges during his confirmation process, according to Yahoo! News. 

“because of judicial ethics restraints, Justice Kavanaugh and his family cannot accept or direct the funds,” reads an update to the GoFundMe campaign. 

Brass Pills, organized the fundraising campaign. On Tuesday, Hawkins posted what he referred to as an “official statement” from Kavanaugh’s representatives distancing the justice from the effort:” data-reactid=”16″ type=”text”>John Hawkins, a veteran conservative blogger who runs a Kavanaugh-inspired “men’s website” called Brass Pills, organized the fundraising campaign. On Tuesday, Hawkins posted what he referred to as an “official statement” from Kavanaugh’s representatives distancing the justice from the effort:

“Justice Kavanaugh did not authorize the use of his name to raise funds in connection with the GoFundMe campaign. He was not able to do so for judicial ethics reasons. Judicial ethics rules caution judges against permitting the use of the prestige of judicial office for fund-raising purposes. Justice Kavanaugh will not accept any proceeds from the campaign, nor will he direct that any proceeds from the campaign be provided to any third party. Although he appreciates the sentiment, Justice Kavanaugh requests that you discontinue the use of his name for any fund-raising purpose.” –Yahoo! News

The GoFundMe page was organized by veteran conservative blogger, John Hawkins, who said he organized the page in case Kavanaugh needed the funds for an attorney or security.

And while Kavanaugh will forever have a #MeToo asterisk next to his name, his accuser, Christine Blasey Ford – who lives in a Palo Alto, CA house worth over $3 million, raked in over $1 million in donations from crowdfunding campaigns, and has reportedly been fielding book offers, according to Paul Sperry of RealClearInvestigations. 

The potential seven-figure windfall, which she says she intends to cash in on – while still asking donors for more money – has some questioning her motivation for accusing the conservative judge after 35 years of silence, and whether it goes beyond personal or even political justice. Others worry the largesse sets a dangerous precedent: Crowdfunding, which unlike political donations is unregulated, could be routinely used in the future as a bounty for providing political dirt on opponents.

Two GoFundMe accounts have raised more than $842,000 for Ford, and the money is still coming in weeks after she testified and left the spotlight. The total does not include a third account collecting $120,000 for an academic endowment in her name. –RealClearInvestigations

“The costs for security, housing, transportation and other related expenses are much higher than we anticipated and they do not show signs of letting up,” said Ford in a recent statement on the GoFundMe page “Help Christine Blasey Ford,” which is still active and accepting donations. “Funds received via this account will be used to help us pay for these mounting expenses,” she claims. 

According to GoFundMe spokeswoman Katherine Cichy, the Fords are able to withdraw as much as they want, whenever they want, for whatever purpose they deem necessary. Once requested, funds would be electronically deposited into their bank accounts within two to five business days. 

Some question the necessity of the financial assistance given that much of the costs associated with Ford’s testimony – including all of her legal fees plus a polygraph examination – were covered by Democratic attorneys assigned to her by the Democratic members of the Senate Judiciary Committee, committee sources say; panel Democrats were allotted half of a $1 million committee fund for transportation, security, investigations and other expenses associated with the tumultuous confirmation process. The Senate Sergeant at Arms and Capitol Police also provided “heightened security” for Ford. –RealClearInvestigations

 “Her lawyers said they were representing her on a pro-bono basis. Why does she need all of this money?” asked an attorney familiar with the committee’s investigation. 

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Yesterday we asked if, as a result of its ongoing operational troubles and recent downgrade by S&P, GE was facing another Commercial Paper “moment”, with a Moody’s downgrade now imminent. The reason is that GE has traditionally been one of the biggest issuers of Commercial Paper to fund daily operations, and used to be one of the biggest issuers of the debt: veteran readers may recall that during the financial crisis, GE’s loss of access to the frozen CP/Money Market nearly resulting in a terminal liquidity crisis at the industrial conglomerate.

Since then, GE’s reliance on commercial paper was material, and in the second quarter, GE had on average around $16.6 billion of the debt outstanding – a sizable portion of its total $116 billion in debt.

A warning shot came in early October, when S&P cut GE’s short-term grade to A-2, a level below the top tier. That’s a rating of commercial paper that some classic prime money market funds are reluctant to buy. In fact, prime money market funds historically had to have at least 97% of their securities rated at least A-1 from S&P and P-1 from Moody’s, but those rules were loosened amid this decade’s money market reform. Even so, as Bloomberg noted, many funds would be far less willing to buy securities with a split rating, i.e., where at least one rating is below A-1 or P-1.

And with fewer funds interested in buying GE paper, the company would be forced to pay higher rates to sell its commercial paper, according to Peter Crane, president of Crane Data, which tracks money market funds. “They’ll still be able to find buyers, but at a cost of course,” Crane said. It cost 2.34% for a top-tier corporation to borrow for 90 days, according to U.S. Federal Reserve data. Companies the next tier down, where one ratings firm has GE, paid 2.71%.

Fast forward to today when moments ago GE found itself completely shut out of the Commercial Paper market, when Moody’s downgraded its senior unsecured rating to Baa1, from A2, and downgraded the short-term rating to P-2, from P-1, making future sales of CP impossible.

The silver lining is that GE had a pretty good hint that the downgrade was coming, and in the quarter ended Sept. 30, it brought its total Commercial Paper outstanding to just $3 billion, while noting that GE Capital will exit that market entirely by the end of this year.

In lieu of CP access, on its earnings call GE said it would replace that funding with a net $40.8 billion of available credit facilities committed from banks. In other words, GE will now use its revolver, which carries a higher interest rate, to fund what it previously achieved using CP. At the same time, GE said it had been working to reduce its reliance on short-term financing: Rising U.S. rates have increased the cost of borrowing short term, and regulatory changes have effectively penalized the use of commercial paper relative to other financing methods. Needless to say, GE can well do that, but it would cost it a few higher interest rate, and considering the adverse impact rising CP rates had on GE stock…

… one wonder a) how much faster the company’s decline will be going forward and b) how long until GE loses access to its revolver as well.

The full Moody’s downgrade is below:

 Moody’s Investors Service (“Moody’s”) downgraded the long-term ratings of General Electric Company  (“GE”), GE Capital Global Holdings, LLC (“GE Capital”) and its subsidiaries, including the senior unsecured  rating to Baa1, from A2, and downgraded the short-term rating to P-2, from P-1. The ratings outlook is stable.

This concludes the review for downgrade that was initiated on October 2, 2018.

RATINGS RATIONALE

The downgrade reflects Moody’s view that the adverse impact on GE’s cash flows from the deteriorating performance of the Power business will be considerable and could last some time. The weaker than expected performance at Power is not only attributable to a considerable drop in market demand and ensuing heightened competition, but also to GE’s misjudgment of financial prospects and operational missteps. In addition to weaker earnings, cash flows in the Power segment are diminishing swiftly due to a decrease in progress collections following a steep decline in equipment orders. As a result, GE’s free cash flow (after dividends) will likely be very weak in 2018, even with good performance at GE Aviation and GE Healthcare. Moody’s anticipates that a decline in progress collections will continue to hamper cash flows in 2019, as demand for gas turbines will remain soft and GE’s market share has recently come under pressure.

The Baa1 senior unsecured rating balances the challenges posed by GE’sPower business with the prospects for earnings and strong cash flows at GE Aviation that are underpinned by a good pace of commercial aircraft deliveries and significant OEM backlogs. GE has significant resources at its disposal and maintains a competitive presence in critical industries derived from technological leadership. The rating also incorporates Moody’s expectation that GE will be able to increase EBITA margins to the mid-teens level, increase FCF/debt to high single digits and reduce leverage to less than 3 times by 2020, assuming completion of the planned spin-off of GE’sHealthcare business.

GE’s liquidity is adequate, but intra-quarter borrowing needs are well in excess of $10 billion and necessitate the company to draw on its revolving credit facilities that have an aggregate committed amount of approximately $40 billion. Moody’s expects liquidity to improve gradually following the decision to eliminate substantially all of GE’s dividend and as the company progresses with asset divestitures.

GE’s strong implicit and explicit support of GE Capital, including through debt guarantees and provision of borrowing capacity on an unconditional and irrevocable basis, results in Moody’s equalization of GE Capital’s senior unsecured rating with the senior unsecured rating of GE.

The stable ratings outlook is predicated on Moody’s expectation that GE will be able to contend with the challenges posed by its Power business, considerable intra-quarter borrowing needs and high debt balance, as restructuring efforts accelerate, its cash balance increases to around $15 billion and previously announced asset divestitures are completed. The availability of other assets that GE could monetize, including its 62.5% ownership interest in Baker Hughes, a GE Company, LLC, helps to mitigate the risks associated with an array of contingent liabilities and offers the possibility for additional debt repayments.

The ratings could be upgraded if growth in Power resumes and operating margins in the Power business recover to more than 10%, while consolidated EBITA margins are sustained at around 15%. FCF/debt of more than 10% and debt/EBITDA of less than 2.5 times would also be supportive of a ratings upgrade.

The ratings could be downgraded if Moody’s expects that GE is unable to halt the decline in Power revenues, to restore operating margins in Power to at least the mid-single digit range, or to successfully fix the turbine blade issue of its HA-class heavy duty gas turbines. The ratings could also be downgraded if GE is unable to sustain FCF/debt at around 7%, in the absence of a steady decline in debt/EBITDA towards less than 3 times, or if GE does not utilize the proceeds from asset divestitures primarily to increase its cash balance, mitigate the risks that arise from contingent liabilities and repay debt.

GE Capital’s ratings could be upgraded if GE’s ratings are upgraded and if GE’s support of GE Capital, including of future debt issuance, remains strong. A downgrade of GE Capital’s ratings could result from a weakening of GE’s support or weaker than anticipated support of future debt issuance. GE Capital’s standalone credit profile could improve if the company strengthens its ratio of tangible common equity to tangible managed assets towards levels comparable to those of finance and leasing company peers and meaningfully reduces its insurance exposures. Conversely, GE Capital’s standalone credit profile could be lowered if liquidity or the operating performance of GE Capital’s aircraft leasing business weakens materially, or if other events meaningfully reduce the firm’s capital position.

GE’s bonds were not happy.

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Authored by James Rickards via The Daily Reckoning,

When will the strong dollar weaken? Ultimately, the answer is whenever the Treasury wants.

When the Treasury is not overly concerned with the dollar, market forces can prevail to raise or lower the exchange rate compared with euros, Swiss francs, yen or any other currency.

Sometimes, other central banks intervene to raise or lower their currencies relative to the dollar and the U.S. does not seem to care. China is notorious for this. Japan and Switzerland are other practiced currency manipulators.

The last fully coordinated currency market intervention was conducted by the G-7 in March 2011 at the time of the Fukushima, Japan, earthquake and tsunami that caused the collapse of a nuclear power plant and ultimately a crash of the Tokyo stock exchange.

The Japanese economy was weakened by the natural disaster. A weaker yen would have helped the economy with cheaper exports and more inflation. But insurance companies had to sell dollar-denominated assets and buy yen in order to pay yen-denominated claims for the disaster losses. The result was a stronger yen.

The G-7 intervention, organized by then French Finance Minister Christine Lagarde, successfully sold yen and bought euros, dollars and sterling to weaken the yen despite insurance companies buying it. Lagarde’s success in this intervention was instrumental in her elevation to head of the IMF shortly thereafter.

In short, except in extraordinary circumstances, the U.S. Treasury does not directly intervene in currency markets to target U.S. dollar exchange rates. If such targeting is needed, the Treasury will work with the Fed to raise interest rates or take a pause in rate hikes to affect the dollar’s value.

All of this may be about to change.

Both President Trump and Treasury Secretary Mnuchin have publicly expressed dismay at the dollar’s persistent strength in the second half of 2018. A strong dollar has adverse effects relative to Trump’s economic plans.

It makes imports less expensive, which has a deflationary impact on the U.S. domestic economy. This is at a time when both the Fed and the White House would like to see more inflation.

A strong dollar also hurts U.S. exports from major companies such as Boeing and GE. That hurts U.S. competitiveness and U.S. jobs. Finally, a strong dollar hurts corporate profits of U.S. global companies because their overseas profits are translated back into fewer U.S. dollars. This is a head wind to U.S. stock market performance.

U.S. Secretary of the Treasury Steven Mnuchin and his wife hold a sheet of freshly printed dollar bills during a visit to the U.S. Bureau of Printing and Engraving. The dollar has been strong during most of the Trump administration since early 2017. However, the strong dollar causes deflation and reduced exports. Trump and Mnuchin will soon weaken the dollar to boost growth.

While the White House and Fed may be united in their desire to see a weaker dollar and more inflation, the Fed is doing nothing to achieve that. The Fed has been on a path of raising interest rates for almost three years, beginning with the “liftoff” rate hike in December 2015.

Since October 2017, the Fed has also been tightening money supply by not reinvesting in Treasury securities when existing securities in their portfolio mature. This “quantitative tightening,” or QT, is the opposite of quantitative easing, QE.

The combination of rate hikes and QT has caused a significant increase in U.S. interest rates in all maturities and, in turn, a stronger dollar as capital flows to the U.S. in search of higher yields. The result is a persistent strong dollar.

This means that if the White House and Treasury want a weaker dollar, they may have to achieve it on their own with no help from the Fed. The Treasury is well-equipped to do this kind of intervention by using their Exchange Stabilization Fund, or ESF.

The ESF was created under the Gold Reserve Act of 1934, which provided legal ratification for FDR’s confiscation of private gold from U.S. citizens in 1933. FDR paid $20.67 in paper money for the gold in 1933, knowing he intended to raise the price of gold.

His plan was to capture the “gold profits” for the government instead of allowing citizens to realize the profits. Those profits were the original source of funding for the ESF.

Importantly, the ESF exists completely outside of congressional control or oversight. It is tantamount to a Treasury slush fund that the Treasury can use as it sees fit to intervene in foreign exchange markets. No legislation or congressional appropriation is required.

Former Treasury Secretary Bob Rubin used the ESF to bail out Mexico in 1994 after Congress had refused to provide bailout money through other channels.

Today, the ESF has net assets of about $40 billion. The gross assets include about $50 billion in SDRs, but the Treasury can issue SDR certificates to the Fed in exchange for dollars if needed to conduct currency market operations. You can find the ESF financial statements here.

The biggest offender in the currency wars today is China, which has devalued the yuan 10% in the past six months to offset the impact of higher tariffs imposed by Trump. China’s cheap-yuan policy is undermining Trump’s trade war policies.

After biding their time, Trump and Mnuchin are ready to lower the boom on China with a cheap-dollar policy after the U.S. midterm elections. Of course, China will not be alone in feeling the impact of the new cheap dollar. Europe and the euro are also in the line of fire.

With this background in mind, what is the outlook for U.S. dollar exchange rates?

The single most important factor in the analysis is that two currencies cannot devalue against each other at the same time. It’s a mathematical impossibility. If one currency is going down against another, then the other must be going up. There’s no other way.

From January 2010 (when Obama launched the currency war) to August 2011 (when the dollar hit an all-time low), the currency wars benefited the U.S. at the expense of Europe, emerging markets and China. This was considered necessary by the participants at the G-20 leaders summit in Pittsburgh in September 2009.

The U.S. was and is the world’s largest economy. If the U.S. could not escape the impact of the 2008 financial panic, no one else would, either. In effect, the world would suffer stronger currencies while the U.S. devalued to jump-start the global recovery.

After August 2011, the dollar was allowed to revalue upward while the rest of the world, especially Europe and China, was allowed to devalue so they could claim some benefit from a weaker currency. This worked in the short run, but the problem was that the U.S. never returned to sustained growth at the prior trend of 3.25% growth per year.

The U.S. endured a long depression from 2007 until today with annual growth of about 2.3%. Europe and China got a boost, but the U.S. never pulled away from the pack.

Since then, it has been a matter of taking turns. The euro is allowed to depreciate to help growth and the banking system as the dollar gets stronger based on a slightly stronger U.S. economy. But no major economy has solved the problem of achieving self-sustaining trend growth.

China has been free-riding the entire time. There have been periods of a soft peg of the yuan to the dollar, but there are intermittent periods of a weaker yuan. China executed shock devaluations in August 2015 and December 2015.

Both times, U.S. stocks fell 11% in a matter of weeks. China has just executed a 10% slow-motion devaluation over the past six months. U.S. stocks have started to sink again.

Now Trump and Mnuchin are saying, “Enough!” The Europeans will have to take their turn with a stronger currency and China will be penalized for their currency manipulation. A weaker dollar is coming.

Whether this will be achieved with cooperation by the Fed or direct intervention by the Treasury remains to be seen, but a weaker dollar is the only way out of the U.S. growth conundrum and debt debacle.

The chart below shows that the euro has settled into a trading range since April after coming down from the $1.25 range in February.

Chart 1:

The euro will break out of that trading range toward the upside ($1.20–1.30) over the next few months. This will be the result of a possible Fed pause in rate hikes as the U.S. economy weakens, continued determination by the ECB to tighten policy and possible intervention by the U.S. Treasury.

Meanwhile, a weaker dollar will give the U.S. another growth spurt after the 2018 tax cuts to help propel Trump’s reelection prospects for 2020.

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Yesterday we discussed why as a result of recent weakness in a handful of shale names coupled with overall bearish market conditions, the Barclays High Yield Energy Index spread had blown out to 452bps, the widest since September 2017…

… making it the worst performing sector in the Bloomberg Barclays HY Index:

Furthermore, this was the biggest one-month move wider in energy HY spreads since the E&P crisis of December 2015/January 2016, when energy junk bonds blew out, as many shale companies defaulted on their debt.

And, according to Bloomberg, after a period of surprising resilience which saw junk spreads touch the narrowest since the financial crisis as recently as a month ago, October was the worst month for junk bonds since 2008.

October has been positive for high-yield bonds in every year since 2008, when the market tumbled almost 16 percent in the month.

And while October has been typically a good month for high yield, this month is on track for the biggest loss since December 2015 as equity volatility, economic fears, earnings and trade worries weigh.

After months of outperformance, U.S. high yield finally cracked, generating a -1.81% return in October, making it the second-worst performer of all the main bond market indexes and exceeded only by the 1.87 percent decline for global high yield.

The October rout wiped out more than two-thirds of all high yield YTD gains, and while the sector is still up 0.72% in 2018, it is well short of the 2.57% racked up by the close on Sept. 28. The former star performer in the space, the “triple hooks” or CCC rated bonds, gave up half their YTD gains, and were up by 3.07%, compared to a 6.24% return at the end of last month. Meanwhile, investment grade bonds are now well in the red for the year, losing 3.5% after a 1.2% drop this month.

Meanwhile, as yields have continued rising on the back of the Fed’s higher rates, yields have moved to increasingly daunting levels, with the average “high” yield rising to almost 7%, up from about 5.5% at the start of this year, and the highest since July 2016. Meanwhile, yields on CCC companies have once again crossed the 10% mark for the first time since January 2017.

While the CCC space has long been a favorite of momentum-chasing credit investors, yields are now high enough to where they may impair cash flows, and will certainly make it more costly for lower-quality companies to raise new funds and pay down or refinance existing debt.

Still, alongside most other asset classes, Bloomberg notes that while junk bond yields rose as returns plummeted, “there has been no panic selling.” And, as has so often been the case, investors who were just waiting for the turn, now say the recent drop is a  buying opportunity, citing strong credit fundamentals, low default rates and a steady economy as factors favoring junk bonds.

They will continue repeating this until the next junk bond selloff, when the liquidation may not be quite so orderly.

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Authored by John Mauldin via MauldinEconomics.com,

Is debt good or bad? The answer is “Yes.”

Debt is future spending pulled forward in time. It lets you buy something now for which you otherwise don’t have cash available yet. Whether it’s wise or not depends on what you buy. Debt to educate yourself so you can get a better job may be a good idea. Borrowing money to finance your vacation? Probably not.

Unfortunately, many people, businesses, and governments borrow because they can, which for many is possible only because central banks made it so cheap in the last decade. It was rational in that respect but is growing less so as the central banks tighten their policies.

Earlier this year, I wrote a series of articles (synopsis and links here) predicting a debt “train wreck” and eventual liquidation—an event I dubbed The Great Reset. I estimated we have another year or two before the crisis becomes evident.

That’s still my expectation… but I’m beginning to wonder again. Several recent events tell me the reckoning could be closer than I thought just a few months ago. Today, we’ll review those and end with a few suggestions on how to prepare.

Addicted to Debt

As noted, debt can be appropriate—even government debt, in some (rare) circumstances. I am glad FDR issued war bonds to help defeat the Nazis, for instance. Now, however, governments go into debt not because they face existential threats, but simply to keep their citizens and benefactors comfortable.

Similarly, central banks enable debt because they think it will generate economic growth. Sometimes it does, too. The problem is they create debt with little regard for how it will be used. That’s how we get artificial booms and subsequent busts.

We are told not to worry about absolute debt levels so long as the economy is growing in concert with them. That makes sense. A country with a larger GDP can carry more debt. But that is increasingly not what is happening. Let me give you two data points.

Lacy Hunt tracks Bank for International Settlements data that shows debt is losing its ability to stimulate growth. In 2017, one dollar of non-financial debt generated only 40 cents of GDP in the US and even less elsewhere. This is down from (if memory serves) more than four dollars of growth for each dollar of debt 50 years ago.

This has significantly worsened over the last decade. China’s debt productivity dropped 42.9% between 2007 and 2017. That was the worst among major economies, but others lost ground, too. All the developed world is pushing on the same string and hoping for results like we saw 40–50 years ago. As my friend Rob Arnott constantly reminds me, hope is not a strategy.

Source: Hoisington Investment Management

Now, if you are accustomed to using debt to stimulate growth, and debt loses its capacity to do so, what happens next? You guessed it: The brilliant powers-that-be add even more debt. This is classic addiction behavior. You have to keep raising the dose to get the same high.

At this point, Paul Krugman and others usually call me a debt curmudgeon and argue the debt doesn’t matter. I point them to Ken Rogoff and Carmen Reinhart’s book from 10 years ago, This Time Is Different, which demonstrates that in every prior debt run-up, over centuries of history, accumulated debt clearly eventually made a difference. There is always an eventual Day of Reckoning.

The US economy is so huge and powerful that our current $24.5 trillion government debt (including state and local) could quite easily grow to $40 trillion before we meet that day. We are one recession away from having a $30 trillion US government debt total. It will happen seemingly overnight. And deficits will stay well above $1 trillion per year every year after that, not unlike now.

Some argue the US has almost $150 trillion of personal and corporate assets to offset that debt. That is true enough, but I think there might be some slight resistance if the government demanded 15% of your total assets, including your house, real estate, investment assets, furniture and goods, to pay off the debt. That would be in addition to your regular taxes, and then they begin accumulating more debt.

Even though you are reading about a budget deficit of under $800 billion this year, the actual amount of debt added last year was well over $1 trillion. That is due to “off budget” items that Congress, in its wisdom, thinks shouldn’t be part of the normal budgetary process. It includes things like Social Security and Medicare—which vary from time to time and year to year—and can be anywhere from $200 billion to almost $500 billion.

And here’s the point that you need to understand. The US Treasury borrows those dollars and it goes on the total debt taxpayers owe. The true deficit that adds to the debt is actually much higher than the number you see in the news. It brings to mind the scene in the Wizard of Oz, when they wizard says, “Pay no attention to the man behind the screen.”

Household and corporate debt is growing fast, too, and not just in the US. Here’s a note from Lakshman Achuthan.

Notably, the combined debt of the US, Eurozone, Japan, and China has increased more than ten times as much as their combined GDP [growth] over the past year.

Yes, you read that right. In the last year, the world’s largest economies are generating debt 10X faster than economic growth. Adding debt at that pace, if it continues, will boost the debt-to-GDP ratio at an alarming rate.

Lakshman continues.

Remarkably, then, the global economy—slowing in sync despite soaring debt—finds itself in a situation reminiscent of the Red Queen Effect we referenced 15 years ago, when tax cuts boosted the US budget deficit much more than GDP. As the Red Queen says to Alice in Lewis Carroll’s Through the Looking Glass, “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

I am trying to imagine a scenario in which this ends in something less than chaos and crisis. The best I can conceive is a decade-long (and possibly more) stagnation while the debt gets liquidated. But realistically, that won’t happen because debtors won’t let it, and they outnumber lenders. Hence, something like the Great Reset will happen first.

The rational course would be to delay the inevitable as long as possible. Yet in the US, at least, we’re hastening it.

Lost Exorbitant Privilege

This month, the US Treasury closed the books on Fiscal Year 2018. It was a success in the sense that the government is still open and doing the things it should. Financially speaking, it was another debt-financed failure.

Source: US Treasury

The federal government spent approximately $4.1 trillion in FY 2018, of which it had to borrow $779 billion on budget and a few hundred billion more off-budget (amount TBD). And over 40% of the on-budget deficit went simply to pay $325 billion in interest on previously-issued debt.

Obviously, the government should spend less. But where to cut? There is no political agreement on that and little prospect of one. Nor, barring an economic boom of a magnitude and duration I think unlikely, are we going to grow out of this. So, I expect continued and even bigger deficits.

Deficits mean the Treasury has to borrow cash, which it does by selling Treasury bills, notes, and bonds. This wasn’t a problem for most of the last decade but is rapidly becoming one as the amounts grow larger.

Thanks to the “exorbitant privilege” I discussed earlier this month, the US has long had many foreigners willing to buy our debt. Now they are losing interest (forgive the pun) because hedging their currency exposure costs more. There are some complex reasons behind this, relating to swaps and the differentials between the US economy and others, but here’s the bottom line: European and Japanese investors can no longer buy US Treasury debt at a positive rate of return unless they want to take currency risk, which most do not. This is a new development.

This might be fine if US investors made up the difference, but that’s not happening, either, and might not be great anyway. Capital that goes into Treasury debt is capital that’s not going into bank loans, corporate bonds, mortgages, venture capital, stocks, or anything else in the private sector, which generates the growth we’ll need to pay off the government’s debt.

Treasury auction data shows it is getting harder to attract buyers. According to Bloomberg, last month’s two-year note auction matched the lowest bid-to-cover ratio for that maturity since December 2008.

Source: Bloomberg

The problem is manageable for now, and Treasury will always be able to borrow at some price… but the price could get awkwardly high, with interest costs rising dramatically.

Given the debt’s maturity structure, it could be sooner than you might think. Treasury took advantage of lower short-term rates in recent years, which reduced interest costs, but also created refinancing risk. Here’s a Torsten Slok chart (via my friend Luke Gromen on Twitter).

Source: Luke Gromen

Looking only at federal debt not held by the Federal Reserve, Treasury will need to borrow something like 43% of GDP over the next five years just to rollover existing debt at much higher interest rates. That’s not counting any new debt we accumulate, which could be quite a lot if we enter recession or (God forbid) another war.

But set aside the hypothetical possibilities. Just the things we know are already locked in, like Social Security and Medicare, are enough to blow up the debt. Somebody has to buy all that Treasury paper. If it’s not foreigners, and not the Fed, and not American savers, we are out of prospects.

Now, buyers will appear at the right price, i.e. some higher interest rate. Barring recession-induced lower rates (which would be a different problem), government borrowing could get way more expensive.

Which is more likely: a double-digit ten-year Treasury yield or a worldwide debt liquidation? Neither will be fun. But I’ll bet that we see one or the other at some point in the 2020s.

Trigger Points

My renewed fear comes from the very real possibility the global economy breaks down in the next six months. Anything could trigger a crisis, and it could well be something no one presently foresees, but here are three candidates.

Corporate Credit Crisis: As a whole, US companies are significantly more leveraged now than they were ahead of the 2008 crisis. We saw then what happens when the commercial paper market seizes up, and that was without a Fed in tightening mode. Now we have a central bank both raising short-term rates and slowly ending its crisis-era accommodations. Recent comments from FOMC members say they have no intent of stopping, either. A few high-profile junk bond defaults could ignite fears quickly.

There are trillions of dollars of low-rated corporate debt that can easily slide into the junk debt category in a recession. Since most public pension, insurance, and endowment programs are not legally allowed to own junk-rated debt, I can see where it could easily cause a debt crisis along the lines of the previous subprime crisis.

Trade war: One reason the US economy seems to be booming right now is a surge in imports. Companies are rushing to build inventory ahead of the 25% tariff on Chinese goods that takes effect January 1. Coming on top of usual holiday season stockpiling, it is jamming ports, highways, and warehouses—generating many jobs in the process.

That’s all good right now, but those truck drivers and warehouse workers will no longer be necessary once the shelves are stocked. Working down that inventory will take months, at least, and the resulting slowdown could ease the economy into recession next year.

We might avert that outcome if the US and China reach some trade resolution, but that doesn’t appear likely. The latest reports say the Trump administration is digging in for a long siege and, if anything, may get even more aggressive against China. Nor does China seem likely to bend.

You may have heard the tennis term, “unforced errors.” Those are mistakes of your own,  not a result of your opponent’s good shots. I think the tariffs may be an unforced error in US economic policy that could cause a serious growth decline, or worse.

European Slowdown: This week, we got October PMI reports from Markit. Its eurozone manufacturing and services index dropped to the lowest point since September 2016, with export-dependent Germany particularly weak. Meanwhile, Italy’s new budget is wildly out of line with its revenue and growth prospects. This threatens to set off another euro crisis. And then there’s the serious possibility of a hard Brexit in early 2019.

In short, Europe (at least some of it) is in real danger of entering recession next year. If that happens, the impact will spread around the globe as the continent reduces imports from the US, China, and elsewhere. Not to mention the potential fireworks if Italy or anyone else actually defaults on debt payments to foreign lenders, i.e. German, French, and other European banks with minimal loss reserves.

If the European Central Bank won’t buy Italian bonds, and the Italians won’t do it themselves, then Italian interest rates could jump dramatically, precipitating a crisis. This is essentially what forced the ECB into its first quantitative easing program. In theory, the Italians were then in compliance. That is not the case today. I have been pointing my finger at Italy for years. It is the linchpin in the whole euro experiment on debt and solidarity.

I could go on, but you get the point. The US economy looks fine just ahead, but problems lurk over the horizon. Bad things could happen soon.

So, what do you do? I have three suggestions.

1. Build a cash reserve: I know every financial advisor says that, but disturbingly few people actually do it. Have several months of living expenses readily available in risk-free cash equivalents. Cash is also an option on buying discounted assets at lower prices in the future.

2. Deleverage: If you carry business or personal debt, reduce it as much as you can and don’t assume you will be able to refinance. Banks can cut your credit lines in a heartbeat, and they will.

3. Have a plan for your longer-term investments, whether they are stocks, real estate, or anything else. Decide now what you will sell, and to whom, because buyers may not be there when you need them. At the same time, decide what you plan to hold through any slowdown. I have assets in private companies and even a few public ones that I truly consider “for the long term.”

I sincerely hope I’m wrong. Maybe I’m jumping the gun here and 2019 will be another banner year. But I see major risks ahead, and I want you to be ready for them.

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