Mon Post #1: Events in Europe, QE and Gold/Silver

To say that we live in interesting times is nothing short of an understatement.

Sovereign Debt will be the issue of this decade and the situation with the PIIGS (Portugal, Ireland, Italy, Greece, Spain) in Europe dominates the headlines again this past weekend.

A stunning article appreared in the UK newspaper, The Telegraph, which reported that Britain's Foreign Office has given instructions to embassies and consulates to begin contingency planning to help expats should the crushing debt of the PIIGS collapse the Euro.

Even more incredibly, a senior minister has revealed that Britain is now planning on the basis that a Euro collapse is not just a possibility, but that it is only a matter of time.

A senior minister has now revealed the extent of the Government’s concern, saying that Britain is now planning on the basis that a euro collapse is now just a matter of time. “It’s in our interests that they keep playing for time because that gives us more time to prepare,” the minister told the Daily Telegraph.

Meanwhile Société Générale (SocGen), a large European Bank and a major Financial Services company that has a substantial global presence, has come out its Multi Asset Portfolio Scenario/Strategy guide wherein the French bank makes the simple case that the worse things get, the stronger the response by global central banks will be.

"A major liquidity crisis should not occur this time, as we think we are on the eve of major QE in the UK, US and (a bit) later on in the EZ."

How big will QE3 be?

According to SocGen, the Fed will preannounce it in the January 2012 FOMC statement and that the monetization will last from March 2012 until the end of the year and will buy a total of $600 billion.

Many analysts believe the actual total will be well greater, probably in the $1.5 trillion range as the Fed will finally say "enough" to piecemeal solutions and grab the bull by the horns.

What really stands out is SocGen's investment advice:

"Buy gold ahead of QE3 as money creation has a strong impact on prices... Gold is highly sensitive to US QE, as every dollar of QE goes into M0, triggering the debasement of the USD."

SocGen sees Gold going to $8,500/oz so as...

"to catch up with the increase in the monetary base since 1920 (as it did in the early 80s)."

Older readers will recall that was a time when Gold went from $35/oz to $850/oz.

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Sovereign Debt

Above is an updated video which offers an easy explanation about the US Debt problem and how it connects to the world debt problem.  It's well worth the six minutes of time to watch it.

Speaking of US Sovereign Debt, former Reagan economic adviser Laurence Kotlikoff was making news this past weekend talking about the U.S.'s "true indebtedness".

"We're focused just on the official debt, so we're trying to balance the wrong books," Kotlikoff said.

Kotlikoff pointed out that if you add Social Security, Medicare, Medicaid and defense expenditures to the mix, the 'real' debt skyrockets.

• "If you add up all the promises that have been made for spending obligations, including defense expenditures, and you subtract all the taxes that we expect to collect, the difference is $211 trillion. That's the fiscal gap."

To Kotlikoff the debate currently going on is misplaced and misguided.

• "Why are these guys thinking about balancing the budget? They should try and think about our long-term fiscal problems. We've got 78 million baby boomers who are poised to collect, in about 15 to 20 years, about $40,000 per person. Multiply 78 million by $40,000 - you're talking about more than $3 trillion a year just to give to a portion of the population. That's an enormous bill that's overhanging our heads, and Congress isn't focused on it."

 As we have said before, Sovereign Debt is the issue of this decade.  The breadth and depth of the fiscal earthquake suffered 3 years ago is only just beginning to be understood and appreciated.

The 2008 Financial Crisis has only just begun.

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Say Whaaa????

There is only one news story today.

Standard & Poor’s took the unprecedented step of downgrading the U.S. government’s “AAA” sovereign credit rating Friday in a move that could send shock waves through global markets when they open Sunday night/Monday morning.

The following is a press release from Standard & Poor’s:

• We have lowered our long-term sovereign credit rating on the United States of America to ‘AA+’ from ‘AAA’ and affirmed the ‘A-1+’ short-term rating.
• We have also removed both the short- and long-term ratings from CreditWatch negative.
• The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.
• More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.
• Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.
• The outlook on the long-term rating is negative. We could lower the long-term rating to ‘AA’ within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

There are calls to fire US Treasury Secretary Tim Geithner for what is now being called a 'disasterous' turn of events and emergency meetings of the G20 to discuss the financial mess of both Europe and the United States.

But as PIMCO notes:

• "There will be endless debate on whether S&P, the rating agency, was justified in stripping America of its AAA rating and — adding insult to injury — even attaching a negative outlook to the new AA+ rating. But this historic action has now taken place, and the global system must adjust. There are consequences, uncertainties, and a silver lining."
• "Not so long ago, it was deemed unthinkable that America could lose its AAA. Indeed, “risk free” and “US Treasuries” were interchangeable terms — so much so that the global financial system was constructed, and has operated on the assumption that America’s AAA was a constant at the core, and not a variable."
• "Global financial markets will reopen on Monday to a changed reality. There are immediate operational consequences, from re-coding risk and trading systems to evaluating collateral and liquidity management. Key market segments will be closely watched, including the money market complex and the reaction of America’s largest foreign creditors."
• "Meanwhile, for the real economy, credit costs for virtually all American borrowers will be higher over time than they would have been otherwise."

America occupies the core of the world’s financial system.

This downgrade will have a wider, systemic impact on the rest of the globe starting with a downgrade of France.

China has released a scathing op-ed in Xinhua, the official Chinese news agency.

• "Dagong Global, a fledgling Chinese rating agency, degraded the U.S. treasury bonds late last year, yet its move was met then with a sense of arrogance and cynicism from some Western commentators. Now S&P has proved what its Chinese counterpart has done is nothing but telling the global investors the ugly truth... China, the largest creditor of the world's sole superpower, has every right now to demand the United States to address its structural debt problems."

In the past this blog has told you that Gold and Silver will rise for no other reason than worldwide uncertainty about Sovereign Debt... and that rise would come in a wild roller coaster ride of rising and falling values.

Buckle up gang, the ride has only just begun.

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The Problem of US Sovereign Debt

Above is an excellent animation of the US debt problem.

Forgotten in much of the debt discussion is the maturing debt problem.  Looming on the horizon is the month of August.

In August the United States has  a $134.3 billion cash shortfall that has to be funded with debt.  On top of that there is $467.4 billion in debt that matures through August 31, and has to be rolled over or the US is bankrupt.

That's half a TRILLION dollars in debt that has to be funded in the month of August alone.

As this great article on Zero Hedge notes,  while the politicians debate whether or not to raise the debt ceiling - their decision only addresses the inability to issue more debt post August 3.  But halting all new debt issuance does't end the problem. $467.4 billion has to be issued at the end of August alone.

Make no mistake, the Federal Reserve will be monetizing that debt with some form of new QE.  They many not call it QE, but there will be QE.

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Greece, the PIIGS and why it is so important

On a day where the main distraction is Ben Bernanke, the Federal Reserve and QE3, the real story remains Greece and the PIIGS of Europe (Portugal, Ireland, Iceland, Greece and Spain).

This issue has never really gone away.  And the average person really doesn't have a clue what all the fuss is about.

Oh sure... it's about sovereign debt, but no one really knows much beyond that.

It all has to do with derivatives, that obscure financial concept that everyone seems to have vaguely heard about but no one seems to really understand.

Derivatives are financial instruments that were created to reduce risk, and their use on Wall Street is known as hedging.

In recent years their prevalence and complexity has ballooned creating new kinds of risk.  The name "derivative'' comes from the fact that their value "derives" from underlying assets like stocks, bonds and commodities.

In the years leading up to the financial crash, banks made billions by selling complex derivative contracts directly to buyers, pocketing hefty fees but absorbing considerable risk as well.

And it is that risk that is the problem.

Although America’s housing collapse is often cited as having caused the financial crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators - sometimes even beyond the understanding of executives peddling them

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman Bros.

In the case of A.I.G., the derivative virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models.

By 2008 these derivatives nearly decimated A.I.G, one of the world’s most admired companies which had seemed to be a sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.       

When all was said and done, A.I.G. needed a $182 billion dollar federal bailout.  And it was all because of these infernal 'derivatives'.

In years past, when financial crises in Argentina and Russia left those countries unable to make good on their government debts, they simply defaulted.

But this time around, credit default swaps and other sorts of derivative contracts have become so common and so intertwined in the financial markets that there are fears among regulators and financial players that a Greek default will wreak havoc among derivatives holders.  

The looming uncertainties are whether these derivative contracts - which insure against possibilities like a Greek default - are concentrated in the hands of a few companies, and if these companies will be able to pay out billions of dollars to cover losses during a default.

If there were a single company standing behind many of these contracts, that company would become the A.I.G. of the euro crisis.

     

The central banks of both Europe and the United States will not say whether their researchers have studied holdings of derivative contracts among nonbank entities like insurance companies and hedge funds.

When Ben Bernanke, the chairman of the Federal Reserve, was asked about derivatives tied to Europe at yesterday's press conference, he said:

• “A disorderly default in one of those countries would no doubt roil financial markets globally. It would have a big impact on credit spreads, on stock prices and so on. And so in that respect I think the effects in the United States would be quite significant.”

Derivatives traders and analysts are debating just how much money is involved in these contracts and what sort of threat they pose to markets in Europe and the United States.

According to Markit, a financial data firm based in London, the gross exposure is $78.7 billion for Greece. And there are many other types of contracts, like about $44 billion in other guarantees tied to Greece, according to the Bank of International Settlements.

The gross exposure of the five most financially pressed European Union countries - Portugal, Italy, Ireland, Greece and Spain -  is about $616 billion. And the broader figure on all derivatives from those countries is unknown.       

    

This is why the Europeans have been wrestling this week with the ridiculous “voluntary” Greek bond financing solution.  They are trying to sidestep a default because they simply don' know what's out there.

And they're afraid.

Afraid of an outright default because the financial industry is still refusing to provide the disclosure needed to understand the depth and scope of the actual problem.

Said Christopher Whalen, editor of  the Institutional Risk Analyst: "They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”       

It is suggested that the depth and breadth of the contagion that might occur among swaps holders in the case of a Greek default is massive.

European leaders have said there’s no way we’re going to let Greece default even though it is abundantly clear to everyone that this is the best solution - just as it was for Argentina and Russia several years ago.

Skeptics fear their commitment is so severe because they aren't really sure what they are dealing with.

When asked what data the Federal Reserve had collected on American financial companies and their swaps tied to European debt, Barbara Hagenbaugh, a spokeswoman, referred to a speech made by Mr. Bernanke last May in which he did not mention derivatives tied to Greece.

At yesterday's press conference, Bernanke said that commonly cited data on derivatives do not take into account the offsetting positions banks have on their Greek exposures. And with those positions, he said, even if there is a Greek default, “the effects are very small.”

(This, of course, is the same Ben Bernanke who swore up and down to congress in 2006 that the subprime mortgage condition was also 'very small' and would not be an issue)

At the European Central Bank, Eszter Miltenyi, a spokeswoman, said: “This is much too sensitive I think for us to have a conversation on this.”           

It is widely believed by many insiders that the financial industry's process for unwinding credit-default swaps couldn't possibly run smoothly if Greece defaulted.

Derivatives tied to a country’s debt do not pay out over time, they pay out on one occasion: if a default occurs. That makes sovereign derivatives  similar to derivatives on corporate bonds and different in some ways from the situation at A.I.G. Under normal circumstances they can be unwound smoothly.  But not if the risk were concentrated in just a few weak institutions.

Derivatives have been called the 'financial instruments of mass destruction'.

Will the derivatives of the PIIGS blow up the financial world the same way the derivatives of Bear Stearns, Lehman Bros and A.I.G. did?

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Jim Rogers on Sovereign Debt and getting ready

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Inflation in Argentia is at 25%

I'm always amazed at the number of people who scoff at the suggestion that inflation is a concern right here, right now.

It is taking hold around the world as we speak.

The latest example comes from Argentia.

Annual price increases in South America’s second-biggest economy are more than 25%, which would make Argentina’s inflation rate the second highest in the world behind Venezuela. Argentina’s statistics agency said prices rose 9.7% in March from a year earlier.

Quickening inflation in South America’s second-biggest economy isn’t a concern only for those trying to buy groceries. Doubts about the government’s data mean investors demand higher yields on Argentine bonds, said Edwin Gutierrez, who manages $5 billion in emerging-market debt at Aberdeen Management Plc in London. The current yields on Argentine debt of about 12% percent are unsustainable, he said.

The extra yield investors demand to buy Argentine bonds over U.S. Treasuries is 696 basis points, or 6.96%, according to JPMorgan Chase & Co.

Compare that to Iraq where the so-called spread for Iraqi bonds is 3.88%. Even the Dominican Republic, whose $46 billion economy is barely one-tenth of Argentina’s, sold $750 million of bonds last month yielding 7.5%. Argentina’s dollar bonds due in 2015, by comparison, yield more than 12.5%.

Surging government spending is behind the price increases, said Daniel Kerner, an analyst at the Eurasia Group in New York. Government outlays before interest payments rose 40.1% in March from a year earlier as revenue increased 39.9% the government said.

Surging government debt, eh?

Good thing we aren't looking at a problem like that here in North America.

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If Greece Is Bear Stearns, Will the UK Be Lehman?

Great little piece on CNBC yesterday which posed the above titled European debt contagion question.

Sunday’s news of a 750 billion euros ($951 billion) stabilization fund and European Central Bank assistance for the European bond market averted a full fledged liquidity crisis, but many remain sceptical that the crisis has past.

Can the governments in Greece and Portugal live up to their end of the bargain and significantly cut government spending in the face of bitter opposition from voters?

“The big question I am asking myself is whether Greece is Bear Stearns,” Anthony Fry, senior managing director at Evercore Partners, said. “What I really fear is that if Greece is Bear Stearns then the UK is Lehman Brothers.”

Fry, it should be noted, worked for Lehman before its collapse.

There is an insistance that the UK will be alright because it has the ability to sell government bonds internally.

Steven Barrow, the head of G10 Research at Standard Bank, holds that opinion. “I am confident about the prospects for the pound,” Barrow said.

The difference between the UK and Greece, according to Barrow, is that Britain has more room for maneuver. “The UK can devalue and print money, the UK will not default, the UK will not need the IMF,” he said.

Sounds like a recipe for currency collapse to me.

And Anthony Fry is adamant that such analysis is nonsense.

“I can’t believe (the UK) can avoid trouble," he said. "The current coalition talks are like arguing over a birthday cake. Once they decide how much of the cake they get they realize no one bothered to bake the cake.”

Fry makes the exact same point I have been making the past few months; with a lot of money needing to be raised over the coming months and years, UK borrowing costs are going to move sharply higher.

“My big fear is that after (Chancellor of the Exchequer) Alistair Darling refused to support the EU/IMF/ECB bailout of the euro zone bond market, the euro zone may stand by and do nothing when the UK gets into trouble,” Fry said.

Fry remains worried about the problems facing Greece will spread to Spain and Portugal despite Sunday night’s unprecedented support.

“Tuesday was a correction post Monday’s huge short squeeze," Gallagher said. "The big question now is whether institutional investors will return to the European bond market.”

Meanwhile Pimco, the world’s largest mutual fund, made the decision to stay clear of a proposed Greek dollar-denominated bond auction last month and that decision was one of the key moments leading up to Sunday’s rescue package. The coming weeks and months, July in particular, will be crucial. That's when €227 billion redemptions come up in the euro zone and with Spain needing to refinance significantly that month.

“What we are likely to see is a two-tier Europe," Michael Gallagher, director of research at IDEAglobal, tpld CNBC. “A double-dip recession in Southern Europe is increasingly likely. Core Europe will slow, but do OK. The outlook to the South is far worse.”

All these agreements are predicated on the EU governments meeting strict budget targets and stepping up debt consolidation efforts. Which means the Achilles Heel in Sunday's agreement is governments resisting expansionary, deficit financing once its economic fortunes begin to falter.

The United States has been unable to break that cycle, what makes anyone think the PIIGS will be able to?

So, if if Greece is Bear Stearns and the UK is Lehman, who will be AIG?

“No comment," Fry said.

I'm willing to be it will be California.

As I said last week: first the PIIGS, then the UK and then... the United States.

Are you prepared?

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Ferris... the miles aren't coming off!

Last week I started to talk about how I believe the stage is being set for a Canadian real estate collapse of historic and massive proportions.

Since the collapse of the dot-com bubble in the late 1990s, western governments have manipulated economic conditions so that we moved quickly from the unwinding of one bubble and into another.

Within a year of the collapse of the Internet Bubble, we moved seamlessly into the Real Estate Bubble. And within a year of the collapse of the Real Estate Bubble we have moved into another bubble… and it’s as if nobody can see that there are any similarities.

The only reason it worked in 2000 (and it didn’t really work then), is because we were able to borrow the money from the rest of the world and spend it. And we were able to live in the delusion that we were getting richer even when we were getting poorer.

We believed this because we looked at our asset prices (real estate and stocks) and we saw the prices going up and we said “hey, were actually getting wealthier”.

But we weren’t getting richer because we were spending money at the same time instead of saving money. We would borrow on the asset value and spend it consuming. And as we spent money, the government counted that money as GDP.

And as long as our GDP was rising then we thought our economy was growing.

But the whole time our GDP was going up, we weren’t measuring how much our wealth was going up. We thought we were okay because some appraiser said that our house was worth more. Or the stock market was still going up.

The 2008 Financial Crisis was simply the inevitable collapse of this ponzi mindset.

But when that collapse happened, it was SO intense…. SO profound... that our political masters panicked.

What happened in September and October 2008 had previously been considered completely impossible and totally unthinkable. We have always been told that the lessons of 1929 and the Great Depression had resulted in changes to the financial system so that NEVER AGAIN could the financial system come close to totally collapsing.

Yet we were within two hours of a complete collapse of our banking system and of our economy... and governments responded with panic measures.

They responded the same way they did each time there was a ‘financial emergency’ over the past several decades... with stimulus money and bailouts. Only this time they did it on a scale that has never been seen in the history of the world.

• In the 1990s the US Federal Reserve had been too easy and loose with money. Interest rates were too low and we created too much money. And that facilitated massive investments in the stock market.
• This created the 1997-1999 NASDAQ bubble. When that market crashed the government responded with even lower interest rates and easier access to stimulus money.
• And the exact thing that had happened with the Internet Bubble... now starts occurring with real estate.

We had the internet bubble because the US Federal Reserve was too easy with money.

Easy money allowed people to invest in companies that were tremendously overvalued. None of the dot.com stocks were paying dividends because none of the companies had a realistic chance of making money. But it didn’t matter. The frenzy was pushing stock prices up so people grabbed all the money they could and kept investing in them.

Recognizing what was going on, Federal Reserve Chairman Alan Greenspan sought to intervene. In 1996 he talked about irrational exuberance and they took him to the woodshed for saying something negative. But he still went ahead and raised interest rates to correct the imbalance.

And the bubble burst.

Of course, when the stock market crashed, a lot of the malinvestments were exposed. A lot of the people working at the dot.com’s were going to have to be unemployed. A lot of companies who were given a lot of capital who shouldn’t have been given capital, were going to lose it all. And a lot of investors who invested foolishly who were going to lose a lot of money.

We were destined for a long, painful recession. Those malinvestments were going to have to be worked off. Capital would have to be reallocated to where it could be productively used, and labour would have to be laid off and rehired as that capital found productive uses.

As painful as it might be, it would be a necessary recesiion; the free market's way of correcting the imbalances.

But government intervened in the free market.

Rather than permit the painful process to play out, government would ‘stimulate’ the economy... again.

As always, the stimulus money created a catastrophe. This time in real estate.

During the dot-com, if you questioned the wisdom of what was happening, the reply was always, ‘you don’t understand the stock market’. Now, when anyone questioned the wisdom of what was happening in real estate, the reply was, ‘you don’t understand the real estate market’.

People were told rents don’t matter to real estate in the same way they said dividends don’t matter to stocks. What evolved was a rationalization that said all real estate would appreciate, year after year, for no other reason than a belief that real estate appreciates.

Everyone bought into the idea that it was going to go up... year after year... just because.

And it made no sense. Were incomes going up each year? Would you be able to charge 10, 20, 30 percent higher rents each year? No? Then why is the value going to go up 10, 20, 30 percent?

And the answer was... ‘it just will’.

And for the last nine years it has, fueled by easy money which is being invested in something that does not make fiscal sense – other than the value of the ‘asset’ seems to be rising by 10 – 30% each year.

The real estate bubble, and the financial services industry it created, has grown stupendously out of proportion.

The 2008 Financial Crisis is a result of the stimulus that created the dot-com bubble, the stimulus that tried to prevent the correcting of the dot-com bubble and the real estate bubble it all created.

A long, painful recession is needed to correct the imbalances.

But by responding in the same egregious manner to the 2008 Financial crisis, another catastrophe is inevitable.

Not only have we failed to correct the imbalances, western governments have liquefyed the system beyond any rational explanation in response to fears the entire system could collapse.

In the United States, the U.S. money supply has been expanding at an absolutely unprecedented rate (more than doubling the monetary base since the collapse of Lehman Brothers).

Fears of inflation – even hyperinflation – have been propagated throughout the blogosphere.

So why are we not experiencing rampant inflation?

Why is the U.S. dollar not falling through the floor?

Well, the truth is that all of this new money has gotten into the U.S. financial system but it is not getting into the hands of U.S. businesses and consumers. In fact, even though the money supply is exploding, U.S. banks have dramatically decreased lending. This has brought us to a very bizarre financial situation.

What we have seen is the U.S. government shovel massive amounts of cash into the U.S. financial system and then watch as the big banks sit on that cash and refuse to lend it. The biggest banks in the U.S. reduced their collective small business lending balance by another 1 billion dollars in November 2009.

That drop was the seventh monthly decline in a row. In fact, in 2009 as a whole U.S. banks posted their sharpest decline in lending since 1942.

So all of this money that the U.S. government pumped into the financial system has been doing American businesses and consumers very little good. That is why we can have a vastly increased money supply and very little inflation.

So if the banks are not lending the money to the American people, what are they doing with it?

One of the things they are doing with it is buying U.S. government debt. While U.S. banks have cut business lending by approximately 350 billion dollars since early 2009, they have meanwhile been purchasing approximately 300 billion dollars worth of U.S. Treasury securities.

So instead of loaning money to American businesses and consumers who desperately need it, a ton of this new money is being used to pump up yet another bubble. This time the bubble is in U.S. Treasuries. Asia Times recently described how this trillion-dollar carry trade in U.S. government securities works...

• Remarkably, the most aggressive buyers of US government debt during the past several months have been global banks domiciled in London and the Cayman Islands. They borrow at 20 basis points (a fifth of a percentage point) and buy Treasury securities paying 1% to 3%, depending on maturity. This is the famous "carry trade", by which banks or hedge funds borrow short-term at a very low rate and lend medium- or long-term at a higher rate. This works as long as short-tem rates remain extremely low. The moment that borrowing costs begin to rise, the trillion-dollar carry trade in US government securities will collapse.

Anyone who has dealt with carry trades in the past knows that when carry trades unwind they can do so very, very quickly and the results can be nightmarish.

And this one will unwind too, causing the bubble it is supporting (US Treasuries) to collapse.

You’ve heard it said that doctors 'practice' medicine and lawyers 'practice' law?

They say this for a reason. These 'professionals' never really know their craft. They learn about past mistakes and try to utilize tried techniques to address problems. When something goes wrong, they learn from it and ‘tweak’ their responses.

It is no different for economists, even those entrusted with running the Bank of Canada and the US Federal Reserve (recall Saturday’s post of a paper by Alan Greenspan admitting how the Federal Reserve had failed).

The ‘experts’ panicked when the crisis of 2008 hit.

And they responded with tried techniques (plus a few new tricks) to address the problem.

The truth is that the U.S. financial system is a house of cards that could fall at any time. A lot of economic pain is on the horizon - it is only a matter of when it comes and how bad it is going to get.

And when it does come, interest rates are going to shoot up like nothing we have seen in over 30 years.

Tomorrow, the reckoning that Canada faces.

To read the next part of our series, click here.

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Debt Market Update: Market 'downgrades' US from Triple A

Healthcare in the US grabs the news the morning, but the real story is this piece from Bloomberg this morning.

Two-year notes sold by the Warren Buffett's Berkshire Hathaway Inc. in February yield 3.5 basis points less than US Treasuries of similar maturity.

Meanwhile debt issued by Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. also traded at lower yields in recent weeks.

This, folks, is what one chief fixed-income strategist described as an “exceedingly rare” event in the history of the bond market.

It means that key corporate debt now trades for lower yields than U.S. bonds of similar maturity.

We're at one of those historic moments in the credit market, when U.S. government bond yields are clearly no longer considered one of the safest investments in town.

It is a defacto move by the debt market to downgrade the value of US debt in advance of the 'official' ratings provided by agencies such as Moody's and Standard and Poor's.

Whatever credit ratings firms may say, markets have now made it pretty clear that the U.S. is far from a risk-free debtor. It's as if markets are already moving yields ahead of a potential cut to the AAA-rating.

And regardless of whether the credit ratings firms actually cut America's rating, the reality is that the old risk-free rating is essentially gone; even it still officially remains... the markets have figured it out.

(Note: this post is the second one today, in addition to the one directly below)

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Through the Looking Glass and What Bernanke Found There

Today I am reminded of the book 'Through the Looking-Glass, and What Alice Found There'. Written by Lewis Carroll in 1871, it is the sequel to Alice's Adventures in Wonderland (1865).

Although it makes no reference to the events in the earlier book, the themes and settings of 'Through the Looking-Glass' make it a kind of mirror image of Wonderland including opposites, time running backwards, and so on.

Kinda like the mirror image of rational finances we are currently seeing in the western world.

Reinforcing that imagery is the Monthly Treasury Statement released yesterday. As Tyler Durden of Zero Hedge asks, what's wrong with this picture?

The United States has completed another month in the red. In February, the budget deficit was $220.9 billion, after receipts of just $107.5 billion with vastly surpassed by outlays of $328.4 billion.

That, btw, is a record.

Yet the interest on the public debt was a mere $16.9 billion (page 13 of the MTS report). The reason, as Durden writes, is because in February the interest on public marketable debt (which as of Monday stood at $8.061 trillion) hit an all time low of 2.548%.

In a normal world, the more money you borrow, the greater the associated risk, and the greater the interest payments on this debt. How is it possible that unprecedented debt accumulation can result in ever declining interest rates?

It's a rhetorical question, of course.

We know the answer. The US Federal Reserve, through complete domination of the entire capital market courtesy of ZIRP and Quantitative Easing, have now turned market logic upside down by 180 degrees.

Can we assume that the Fed can forever keep rates on debt at record low levels?

The only way that will happen is if the United States engages in Quantitative Easing to Infinity. If that becomes the only course of action, at some point all that money will have to enter the money supply and - voila! - hyperinflation.

Now we already know that current US Fed chairman Bernanke insists he won't do that. He delivered a blunt warning on U.S. debt and outlined how the stage is set for a Greek-style debt tragedy in the United States if dramatic action isn't taken on the national debt because the Federal Reserve won't monetize the debt with QE to infinity.

Does it look like the politicians heeded Bernanke's warning? Do you see how the United States is racing towards a cliff's edge?

If Bernanke remains true to his word, then you can understand former US Fed chairman Alan Greenspan's concerns when he said that he keeps daily watch on the interest rate on 10-year Treasury notes and 30-year Treasury bonds and calls them the "critical Achilles' heel" of the US economy?

Those spreads are some point are going to spin wildly out of the control at a moment's notice as investors come to full grips with what is looming on the horizon.

The only reason we haven't encountered that scenario is because the QE hasn't ended yet and because no one believes Bernanke won't continue with the policy.

And who can blame them?

Ask youself, what happens if the Fed ends the practice of keeping rates on debt at record low levels?

Currently income from taxes in the United States are plunging. Despite platitudes to the contrary, the economy is not rebounding and incomes are not rising - they're falling. Thus income from taxes are plunging dramatically.

Meanwhile the expenditure side of the ledger has exploded, and not as a function of debt funding: the bulk of outlays have to do with entitlement programs (social security, medicare, etc).

As expenses rise and income falls, it can only mean one thing: more debt.

Recently the debt ceiling was raised to $14.3 trillion which is expected to be hit in less than a year. Observant readers will recall that the previous ceiling of $12.4 trillion was supposed to last the US until the end of March.

Not only was this number passed over a week ago, it is now (less than halfway into the month of March) at $12.5 trillion. Left as it was, the US have broken the debt ceiling far in advance of expectations.

[And remember. This is a debt CEILING... the level goverment won't allow debt to pass!!!]

Obviously this leads us to believe that the $14.3 trillion ceiling will likely have to be raised once again.

Bernanke said the stage is set for a Greek-style debt tragedy in the United States, and he isn't kidding. Consider...

• Just as recently as September 2007 the interest rate on marketable debt was nearly 5%. It plunged to 2.5% in a year. Even the mere mention of actual tightening will spring rates right back to 5%. What does that mean for actual outlays?
• If total debt hits $14.3 trillion it will mean the marketable debt will be about $10 trillion, and the incremental 250 bps of interest will mean about $250 billion of additional interest outlays a year, or half a trillion annually.
• That comes to about $42 billion a month in interest payments alone.
  

In January 2010, $42 billion dollars represents double the amount of all money collected by the United States in income taxes.

If interest rates are allowed to rise, it will decimate the United States of America.

The bottom line is that either Bernanke will be true to his word and the bond vigilantes will force America into the same brutal debt management as Greece or Bernanke is going to pull the United States permanently to the other side of the Looking Glass and give us quantitative easing to infinity.

Do the math and the conclusions are inescapable.

We are going to have either sky-high interest rates from sovereign debt problems or Bernanke will trigger significant inflation with QE to infinity.

What more do you need to know when discussing the future of real estate in Vancouver and Canada?

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Decade of Debt Reckoning

When all is said and done, I believe historians will look back at this time and call it the decade of debt reckoning.

The unfolding financial crisis is one that began with bad bets on securities backed by subprime mortgages, lead to a tightening of credit between big banks and then spawned one of the biggest orgies of government aid that has ever been seen... all of it borrowed.

The lexicon of the day has moved from 'subprime' to 'sovereign debt'.

And it's not just America and the UK that is deeply in doo-doo. Throughout the western world the notion of government debt as salvation and the road to prosperity has reigned supreme.

Issue debt, and you will prosper.

It is as if they have all been blind to recent history when, for an entire decade, many nations of Latin America demonstrated clearly that debt as a road to prosperity was a delusion.

Now the world is poised to forcibly relearn that lesson.

The Greeks are in the process of dealing with those consequences and joining them are Iceland, Ireland, Portugal, Spain, Italy, California, New Jersey, and Illinois... all now paying the price for their debt binges.

And yet, in the face of looming disaster, the United States continues down the merry road to the same financial Armageddon. The Congressional Budget Office now estimates the Obama Deficit will be more than $9.7 trillion over the next ten years, rather than $8.5 trillion.

Truth be told, I don't think (in the long run) that the European Union will collapse over the financial mismanagement of individual states nor will the U.S. crumble from the financial disasters in California, New Jersey, and Illinois.

But deficit spending, nationalization of the health care system and increasing taxation will create business killing regulations in the United States; moves which will crush any possibility of economic growth.

Either bond vigilanties will punish America or the reality of a highly damaged economy will force the Federal Reserve - regardless of Ben Bernanke's current claims to the contrary - into serious and overt monetization of the Obama Deficit. Personally I belive the looming tough times for America virtually guarantees the latter.

And that will cause inflation to again be a problem.

Either way, interest rates will soar and Time will be proven to be 10 years too early with the magazine cover pictured above.

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Inevitable

The swirling economic ill winds continue to blow strong in Europe and we ignore what is going on at our own peril.

Tiny Iceland has used a referendum to express their outrage at being asked to take on the obligations of bankers who allowed the island’s financial system to create a debt burden more than 10 times the size of the economy. The populace is refusing to allow it's government to compensate the UK and the Netherlands for depositor losses stemming from the collapse of Landsbanki Islands hf (Icelandic internet bank) more than a year ago.

Meanwhile, despite some help from abroad and some attempts at internal reform, investors are still leery of Greece. Today, Greek ten-year bonds sell at yields north of 6%, nearly 300 basis points higher than similar maturities in German, Danish, or French sovereign bonds.

Next on that scrutiny list will be the United Kingdom.

With a debt ratio rapidly approaching Greek levels, the pound sterling has lost about 25% of its value even against the US dollar. The massive debt and misspending of the past three administrations, has led to serious out-flows from sterling and UK government ‘gilt-edged’ bonds, or ‘Gilts.’

The previously unthinkable notion of a British default has crossed into the realm of possibility. As a result ten-year British Gilts are selling off to yield above 4%, a significant premium above the country’s Continental rivals.

In other words, the free market has priced in a loss of the UK’s prized ‘triple A’ credit rating, even though the rating agencies have only issued warnings.

There is a shift now occurring in the great economic crisis of 2008 - 2010.

The first wave caused individual people and companies to face bankruptcy. The looming second wave threatens entire governments.

And it is one thing for prudent, rich states like Germany to bail out small states like Greece. But few states have the ability or the will to bail out financial giants like the UK.

The IMF is a sort of ‘central bank of central banks,’ but it is largely backstopped by the United States. Will China, Germany, or other creditor states be willing to assume the role of global guarantor?

And what of the United States?

Although the Federal Reserve is actively holding down the short end of the yield curve to near zero, 10-year notes are currently yielding more than 3.6%. If the Fed were to cease purchasing Treasuries, or the rating agencies were to become realistic, the free market would drive the 10-year rate into dangerous territory.

In Britain the free market is driving up rates despite the fact the rating agencies have not acted yet.

As I have said before, economic conditions all but guarantee the return of sky high interest rates. It's coming, just look around at world economic conditions.

It is as inevitable as the fate of this mouse...

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Black Swan

Notwithstanding recommendations from the likes of the CD Howe Institute, the reality is that the Bank of Canada is going to have to dramatically increase the bank rate here very shortly.

StatsCan reports that growth was a blistering 5% in the last few months of 2009, way above expectations. Virtually every mainstream economist is now saying that the Bank of Canada has every justification it needs to start in on a string of interest rate increases, starting in about 3 months.

The surging economy "increases the odds the Bank of Canada will begin to hike interest rates in July and stay on that path in the following decisions,” says the Bank of Montreal.

Rates are going up.

The only question is: 'how fast' and 'by how much'.

Which brings us back to the issue of sovereign debt and Greece.

The image posted above are the Debt vs. GDP ratios of the world's larger economies according to the Wall Street Journal (click on image to enlarge).

Note that Greece's debt versus GDP sits at a shade over 125% versus the USA's near 100% ratio. Japan comes in as the debt champion at a 200% debt load versus GDP.

So... ummm... exactly how is the western world all that different from the Greeks?

The answer is that the Greeks don't have a currency that they can devalue in order to help inflate themselves out of their debt.

Japan would be toast right now if they were in the same situation with a currency like the Euro that they couldn't manipulate.

Because the Greeks don't have this ability, it has increased the perception of the risk that Greece could possibly default. That's what's making it very costly for Greece to sell bonds in order to fund itself.

What's amusing is watching the central banks in the UK and Japan scramble to avoid becoming the next Greece. The British Pound has taken a brutal beating as some speculators believe England may be the next country to suffocate in their own debt.

But as we noted two days ago, there is no smugness in watching what is playing out overseas because even Ben Bernanke and Alan Greenspan are concerned.

And with good reason. USA government debt is 90% vs. GDP as opposed to the 130% debt vs. GDP ratio in Greece. Anyone who thinks the US is at a lower risk than Greece is only deluding themselves. It's much like telling yourself that you are at a lower risk of having a heart attack when you are 290lbs versus being 330lbs!

The biggest worry is that investors begin to panic over the sovereign debt worries of several countries all around the world.

This could potentially trigger a wild fire as the world realizes that all of the modern economies minus China have the same problem.

The subprime crisis is a good example of watching how one tiny domino can make them all come tumbling down. If the debt spreads begin to blow out on the sovereign debt of several countries like the spreads blew out in the United States with mortgage backed securities back in 2008, then we are going to see one hell of a fiscal tidal wave.

As we have already noted... Bernanke and Greenspan both see the threat and have been moved to comment publicly on it.

Greenspan keeps daily watch on the interest rate on 10-year Treasury notes and 30-year Treasury bonds and calls them the "critical Achilles' heel" of the economy.

And that's because those spreads could spin wildly out of the control of his buddy, Ben Bernanke, at a moment's notice.

It represents the quintessential 'black swan' occurrence; those high-impact, hard-to-predict events that are beyond the realm of normal expectations.

But I ask you... would such a scenario really be all that unexpected right now? And just how stupid is it if you don't make moves to protect yourself?

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