Tuesday, July 28, 2009

Joe Shareholder gets Kung Pau'd by Chinese owned debt

The US has benefitted greatly from an abundant infusion of rich Chinese culture/influence over the last several decades. Specifically, egg drop soup, sweet and sour chicken, lemon chicken, deep fried wontons, egg rolls, General Tsjoe’s chicken, mu shu pork, bang bang ji, and fortune cookies. (Joe, lower east side Manhattan)

What else has China done for the US? How about its willingness to purchase United States Treasury bonds notwithstanding a swelling budget deficit. China has been the largest investor in US Treasury debt, which has provided much needed funds during a severe revenue shortfall. The US Congress has passed legislation after legislation, all designed to boost the economy and jumpstart spending again. However, it is actually the Chinese government, rather than the US government, that is funding the stimulus bill, TARP, cash for clunkers, housing credits, energy credits, etc. All of these efforts have all been fully dependent upon the financial backing of foreign entities. (Joe Lumbar Support….monetary style)

So now that we have a bloated deficit and the US economy is still limping along, what are China’s options?

Eventually all investors need to realize a return on their investment. In the case of China, this will mean slowing the flow of money into the US economy and expecting the interest on the debt to flow back into China. The Chinese government has to be concerned about two things however:

1. The US’ ability to pay back the debt. There are only two things you can do with debt, pay it back, or default it. If the US can’t pay back this debt and defaults, China will unleash Bruce Lee reincarnate in one of those export containers filled with Lo Mein noodles in order to Kung Fu his way across the US. (Joe up the Yangtze River without an oar)

2. Inflation on the US dollar. If the US economy fails to stabilize soon, and fails to substitute tax revenue from economic growth in place of selling debt internationally to fund government operations, then the printing press will be cranked up a level from “high” to “fancy green toilet paper” status, and hyperinflation will set in. Of course hyperinflation will ruin Chinese investments which have been purchased at fixed interest rates. (Joe - Fiber One or broccoli, broccoli beef in this case)

If China stops buying our Treasuries now and our number one source of revenue dries up, panic could set in. If this happens, the US economy - which is on extremely fragile footing anyway, could begin spiraling downward again. Should this happen, the chances of defaulting on the debt would be even greater. This scenario would be similar to financing the first three years of Joe’s medical school, but withholding cash for the fourth and final year just before he graduates and gets the six figure income he expects – enabling him to pay back the loans. Truthfully, however, Joe has no plans to go back to school after flunking out of St. Joe’s in Philadelphia almost a decade ago.

So what is China to do now? Undoubtedly, there are Chinese officials having a difficult time sleeping at night thinking about these difficult decisions. (Joe Wang, extra strength Ambien at night, restless leg syndrome during the day)

So what does this mean for Joe?

Well, Joe and JoAnn just sat down for a formal meal at the Panda Express. After convincing JoAnn that the Chinese custom is to only order one drink and to share a straw; and after he convinced her that she wasn’t holding the chopsticks the right way, so he should probably help her hold them while holding her hand in his; and also after breaking open a cookie before the date and inserting a typed out fortune advising her to “accept her next proposal”, he popped the question right then and there. “JoAnn, what should the current Chinese predicament mean to my investment strategies in stocks?” After a sigh of relief, JoAnn wisely replied, “Be careful about your investments until the economy has sufficiently turned around and we have stiffened our fiscal policy”. Joe then thanked her for the advice, and started in on his fried rice on Kung Pao chicken.

Thursday, July 23, 2009

Joe Shareholder contemplates Treasuries v. Economic Growth

Everyone in the financial world is excited about a possible economic recovery in the third quarter. Signs of stabilization in domestic earnings and economic indicators seem to suggest the end of the recession is near. Economic recovery "Green Shoots" have many investors excited to dive head first back into the markets. Who cares about water depth, right, just dive in? Wrong, the economic recovery water is very shallow, and the concrete underneath the shallow water is the rising US national debt. (Joe Deficit)

As we all know the United States has a budget deficit of over one trillion dollars. So how do we finance expenditures if we're in the hole? We sell debt. The Treasury Department holds weekly auctions to sell US bonds to interested investors at about 3-4% interest. The weekly bond auctions are currently ranging from 30 billion to 200 billion per week. This money is extremely important because it subsidizes tax revenue shortfalls for all government programs, including employee pay and pensions, military expenditures, corporate bailouts (should this even be in the list), etc. So right now we need Treasury auctions because we're broke.

Anyway, suppose the economy starts to improve next quarter, which could happen. If the equity markets (stocks) start to boom, and the market’s expected return is say 10-20%, or even 50% over the next couple years, why would anyone invest in our US bonds at 3% yearly return? They wouldn’t, and either a vital source of revenue would dry up - or the more likely scenario - rates would be pushed higher during treasury auctions, to say 10% on the 10 year treasury bond to lure in buyers. There are several problems with that:

1. Every dollar the US gov borrows would be very expensive at 10% interest. US Treasury would have to lower the amount of US bonds at auctions, which would dry up funds. Who would bailout the banks next time? Who would pay entitlements? Nationalized Health Care? How would the military be financed? Cap and Trade? (Joe-bal warming)

2. The US housing market needs low interest rates. Housing mortgage rates follow the 10 year treasury bond very closely. If the yield on treasuries is driven up to 10% because of a lack of demand at auctions, then the rates on mortgages would be pushed up to about 12%, which would cripple a fragile housing market. You think you're upside down in your mortgage now? (Joe Housing .....spelled upside down)

3. Right now the Federal Funds rate (interest rate at which banks borrow from the Federal Reserve) has been cut to zero by the US Federal Reserve. When you buy a house, your bank/lender can borrow the money at zero interest and lend it to you at 5% interest. If the treasury yields skyrocket, however, the Fed won’t be able to hold these rates at zero long, because they’ll be paying 10% and loaning it out at 0%. Not sustainable for long. This rate increase will negatively impact business loans as well, and credit markets could easily seize up once again, separating borrowers and lender. (Joe minus Kate and the eight)

Enter the US debt into the picture. If we didn't have such a huge national debt, we wouldn’t depend on treasury auctions to pay soaring interest on existing debt, and the auctions would be scaled back significantly from 200 billion per week to almost zero. Under this scenario, depressed supply would meet low demand at low interest. However, since our government desperately needs revenue we will need large treasury auctions and the rates will likely be driven upward (low demand, high supply). The only way out of this debt trap is a booming economy, where tax revenues would offset the need for treasury auction revenue. Most economists suggest this is unlikely, especially with dangerously high levels of unemployment. (Joe Monster.com)

Why don't we just print money? Because just printing money not collateralized by interest would lead to hyperinflation and the US dollar - which is supporting a huge deficit - would simply go down the drain. (Joto Rooter)

In summary, our national debt has economic growth hamstrung right now because rising equity markets will spur interest rate hikes. The only sensible exit strategy is to ween the government off the important revenue stream of treasury auctions and cut the deficit. Because of the inverse relationship between debt and recovery, every dollar that we spend will actually hurt chances of recovery, not help.

So what does this mean for Joe Shareholder??? Joe Shareholder and his friends Joe Investor and JoAnn Trader desperately want to jump back into the market to make money to buy a boat, dirt bike, and maybe even a trailer to haul it. Maybe even a truck to pull it. F-350 Turbo Diesel maybe, with knobby tires. However, beware of this stock market rally. You might go broke. (Joe Soup Kitchen) The threat of rising interest rates due to our National Debt could cause more market shrinkage than a cold swimming pool nestled in the middle of the shrinking polar ice caps. (Joe Gore)