Market Watch: Government bonds: financial disaster

In the June Market Watch article, we discussed the possibility of a bond market crash. Since then, yields on bonds have zoomed. Bond prices have dropped dramatically. Government bonds are decreasing in value because the public is unwilling to take interest payments of 1.5% to 2% annually for the risk of holding government debt. Bond buyers are aware of the fact that U.S. spending is much more than tax revenues.

They see the market can no longer sustain such borrowing to support government spending.

The Fed has controlled interest rates as long as it could; now the law of supply and demand is taking over the bond market. Of all federal government annual expenditures, 43% must be borrowed. There is no way out of the dilemma without drastic cuts in government spending. Because the entire 43% deficit goes to welfare recipients, politicians are unwilling to cut the deficit and risk the loss of votes of the 40% of our population that is receiving welfare benefits.

Politicians want us to believe a “modest” tax increase is needed to close the gap between government expenditures and the income taxes. The top 10% has increased total income taxes paid from 55% of all income taxes in 1986, to 71% of all taxes paid today.

Why not move the amount paid by the top 10% of taxpayers to 80%?
Capital always flees from confiscatory taxation, taking jobs and investment with it. Furthermore, and, unfortunately, an increase to 80% of all income taxes, paid by the top 10% of taxpayers, would provide only a modest dent in the government’s deficit.

Look at three “leadership states”: New York, Illinois and California,represent almost 25% of our population. They are all broke. There are more people on welfare than there are people working. Taxes have become so great that the most productive and wealthiest citizens have moved to other states. What is happening to those states is the same thing that has happened to the city of Detroit. They are insolvent. The stock market is way overpriced. If the Dow were selling at average values, the market would be at 9,000 points, not the 14,800 points today. The stock market’s excessive values are a result of government making $85 billion of new money a month available to the “too-large-to-fail” banks. This new money is made out of nothing but paper, without a lick of sweat or hard work involved.

Easy money always finds its way into the hands of speculators first, whose trading activities keep the stock markets at unrealistic levels … until the market crashes and reminds us what the words “average values” mean.

Interest rates have increased more than a point since April. Our best bet for investing money over the next several years might be to retain strong cash positions and have a healthy amount of hard assets such as real estate, gold and silver. At our increasing pace of government spending and commensurate printing of millions of dollars every day, we’ll experience much more inflation in the next 25 years than we have in the past.

If we don’t own many bonds, why should an investor be concerned?
Total U.S. outstanding debts are $53 trillion. Federal government debt alone represents $17 trillion. At last year’s interest rates, the government paid almost $400 billion a year in interest costs. Reasonable interest rates of 6%, which is where the market is heading, would increase the cost of government borrowing to interest payments in excess of $1 trillion annually. Those increasing interest burdens will lower corporate earnings. Lower corporate earnings means falling stock markets. The interest burden on non-U.S. government debt would increase an additional $1.5 trillion. Added to the increased federal government financing burden of $600 billion, the GDP would theoretically have to absorb additional interest costs of $2 trillion annually — impossible in a $15 trillion GDP.

Can’t the Fed just continue to make money until things smooth out?
Yes, however, a good deal of the banking industry’s capital is comprised of federal government debt. Banks make loans collateralized by that debt. As interest rates increase, bonds decrease in value, so the banking industry’s capital is shrinking. Outstanding loans will have to be called in so that the bank’s capital ratios are met. Leveraged businesses will be in trouble if their loans are suddenly liquidated and short-term borrowing ceases to be available. This has happened in every crisis the last 40 years.

The public thinks that earnings move markets, but that’s not true. What moves the market is what people are willing to pay for those earnings. That is referred to as the price-earnings ratio. The current price-earnings ratio on the Standard and Poor Index of 500 stocks is almost 20 times earnings.

We have seen a huge deflation in the price of overvalued hard assets, the best example of which is real estate. Those markets are in the process of correcting their values to reasonable levels. This correction (deflation) in paper assets, such as stocks and bonds, is only in the beginning stages. The “new money” put into the banking system of $1.2 trillion annually the last several years has “propped up” paper asset’s values.
Earnings don’t move markets.
Caveat Emptor.

George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.