Some Predictions For 2009

The graph above is complete absurdity.  I thought with this post I would try to spend some time thinking about my predictions for 2009.  I figured that this graph of the US dollar would probably be the best place to begin.  I looked at the US Dollar index over the last year and it is surprisingly higher, so far, in 2008.  It began the year in 2008 at around the 77-78 level as seen by the horizontal line and as of this writing it is currently around 81-82.

This fact alone struck me as completely absurd.  How could the US dollar finish the year higher, given the fact that the Fed has completely destroyed the balance sheet, pumped trillions into the financial system and taken nothing as collateral except for an increasing unemployment rate and the deteriorating balance sheets of millions of Americans?  There is not any sound reason for the US dollar to be higher.

Over the next couple of years, the Federal Government will embark upon the greatest refinancing project ever undertaken.  The Federal Government will begin the arduous process of trying to sell “junk” bonds to the rest of the world, while convincing buyers that quality still remains AAA.  How can our debt still be rated AAA?

Does anyone still really trust that Moody’s and SP are being truthful in assigning the USA an AAA credit rating?  These credit rating agencies are the ones that could not foresee the banking crisis, the mortgage crisis, the municipal insurance crisis etc.  Why should we trust that they will forsee the coming currency crisis?

Assume for the minute that the USA’s debt is no longer AAA.  Let’s rightly consider that USA’s credit rating has deteriorated (it has).  What is holding up the US dollar?  Air?  It’s the willingness of foreign nations to continue to want to hold our US bonds.  With interest rates near zero, foreign buyers must be willing to hold US debt with very little return.  Why would they want to hold our debt? They believe that default risk is small. Is it really?

The perceived “lack of default” risk is one of the biggest reasons that foreign buyers will continue to accumulate our national debt.  The buyers truly believe that the USA will pay off all of its obligations and will not default.  Is this a valid belief?   I think so…for a while anyway.  The USA has demonstrated that it will fulfill its obligations to foreign debt holders by creating more debt. Can this go on indefinitely? I think not.   Is this method of fulfilling obligations going to create additional problems for the world economy?   I think so.

In an economy that is growing and prospering,  a nation’s debt is supported by strong growth in tax revenues from individuals and businesses that are benefiting from actual growth in the economy.  People are working for businesses that are creating goods and services that people want and need.  The income from their work is sufficient to support their standard of living.  This economic strength is carried over into the credit markets.  Prospective buyers of debt would perceive the strength in the economy and would be encouraged to hold debt as the likelihood of re-payment would be great and the return would be good.

Contrast that scenario with today’s situation in the USA.  Workers struggle to find employment.  Jobs are disappearing rapidly.  The economy is contracting.  Retail sales are declining.  Home prices are declining.  Stock and paper assets are declining.  Credit is contracting.  Banks are unwilling to lend.  This scenario is a much different one than that of a vibrant growing economy.  In this environment, will bond holders want to continue to hold our debt?   Only if the risk of default is greater somewhere else.  Apparently this is the case.  The world perceives that the US still has lower chance of default than other nations.

The question becomes…How long can this go on?  Is there a limit to how much US debt foreign governments are willing to hold?  When will that limit be reached? What other problems will this massive creation of debt cause the economy to suffer?  The debt the US is creating needs to be serviced by tax collections from its citizens and businesses.  The debt siphons productive assets away from productive growth opportunities in the private sector and channels those funds, in the form of interest payments to service government debts. It’s a death spiral.

Eventually, the likelihood of default increases.  Buyers become unwilling to purchase the debt and interest rates spiral higher out of control and the social structure of the nation falls apart.

It has become evident that as China continues to purchase our debt, the US government directs those assets to various industries.  The areas that funds are directed to  are the areas that could cause harm to counterparties and thereby raise the spectre of default on US Government debt.

Here’s a couple of examples:  Fannie Mae (FNM) and Freddie Mac (FRE) are two “quasi” government agencies.  They were not considered “direct” obligations of the US Government, but it was implied that the USA would support them in the event of a possible default.  Foreign governments owned large amounts of FNMA and FRE.  When it looked like they would fail, USA stepped in and backed them.  AIG (AIG) is a another institution with huge counterparty risks.  The USA stepped in and supported them.  GMAC, GM (GM), and Chrysler  all companies that carried huge exposures.  The USA stepped in with all of them.  Why?

The reason why the Treasury is supporting all these entities is that they cannot give any credence to the theory that the USA might let those major entities fail and create problems for the counterparties.  Why?   The perceived increase in default risk would bring into question the likelihood that the USA might actually default on its own debt.  I think that most of the bailouts that we’re witnessing are being done to demonstrate to the rest of the world that we will not let default happen.  Counterparties are being kept whole.  If counterparties were forced to take actual losses as entities (AIG, BS, FNMA, FRE, MER) were allowed to fail, those same counterparties would become skeptical of the USA and the foreign appetite for US debt would start to shrink.

The USA needs to continue to demonstrate to the world that they will not default at all costs.  As soon as the world perceives increased risk of default, the game is over and we will not be able to sell our debt.  We will not survive as a country at that point.  It’s a terrible and scary situation.

Let’s consider 2009 from an investment point :

• US dollar - Lower as perceived default risk moves higher.
• Stocks - S&P 500 (^GSPC) = 600. Stocks redeemed to live on.
• Gold - Higher as willingness to hold non-currencies increases and in light of default risk on US debt.
• Oil - Lower during recession; deflation take hold in 2009.  Industry grinds to a halt.
• Food prices - Higher as demand for food remains. Prices move higher (inflationary).

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