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The Daily Reckoning Wednesday, January 25, 2010 A $3.8 trillion dollar budget...and the "rich tax" proposed to pay for it, Debts and deficits: Putting those spending proposals into perspective, Plus, Bill Bonner on governments gone wild and other dirty laundry... Eric Fry, reporting from Laguna Beach, California... In yesterday's edition of The Daily Reckoning, our resident short- selling specialist, Dan Amoss, explained why he believes REITs - and especially hotel REITs - offer a delectable short-selling opportunity. Dan returns today to punctuate his bearish analysis of the REIT sector with an equally bearish analysis of Treasury bonds. "I'm a bear on Treasury bonds," Dan says unapologetically. "Prices should go down and yields should go up as the creditworthiness of the US government deteriorates." If long-term interest rates were to rise as much as Dan expects, the REIT sector would suffer more than most other market sectors. REITs are interest-rate sensitive on at least two fronts. First, since most REITs used borrowed funds to amass their property portfolios, any increase in interest rates would increase their cost of capital, thereby squeezing profits. Secondly, most investors consider REITs "yield instruments." As such, REITs, much like bonds, will rally when interest rates are falling and fall when interest rates are rising. In the column below, Dan presents persuasive arguments for selling long-dated Treasury bonds. But first, please allow your California editor to perform a warm-up act by providing his own argument for selling Treasury bonds. Your editor's argument is embarrassingly simple: Sell bonds because the US government is borrowing crazy amounts of money. As the nearby chart illustrates in grisly detail, the US government has amassed $1.8 trillion of new indebtedness during the last 15 months. Astonishingly, each and every one of the last 15 months produced a deficit, including the tax-collection month of April, which had produced a surplus for 26 straight years. So how much is $1.8 trillion, anyway? Well, let's see... It's about 13% of US GDP. $1.8 trillion is also about double what the IRS collected from all individual taxpayers last year. In other words, if every American taxpayer had simply agreed to double his or her tax payments last year, the nation could have avoided this whole deficit mess. For one final bit of perspective, $1.8 trillion is more than double the total debt America had accumulated during its first 200 years as a nation. America's debt load did not crack the trillion-dollar level until after 1980. These days, we rack up 200 years worth of debt every six months or so. Thus, from a purely mathematical standpoint, trillion-dollar annual deficits seem incongruous with 30-year Treasury bonds yielding less than 5%. Less than 20%, maybe. The initiatives that are aggravating America's runaway budget deficits are so mindless and uncoordinated they are, to paraphrase White House Chief of Staff, Rahm Emmanuel, "profanely moronic." As these moronic initiatives pile trillion-dollar deficits atop one another, Treasury bond yields might go to 20% at some point...or the dollar might go to three euros...or both. For more about what's wrong with Treasurys, check out Dan Amoss' column below... --------------------------------------------------------------- The Daily Reckoning PRESENTS: If you missed Part I of Dan Amoss's "sell REITs" column, you can check out yesterday's issue here. In today's issue, he makes the bearish case for... Well...it's all in the essay title. Enjoy... The Case for Higher Treasury Yields...and Lower REIT Prices By Dan Amoss Jacobus, Pennsylvania The prospect of rising Treasury yields will pressure REIT valuations. "Yield instruments" like REITs are priced to yield a "spread" over Treasuries. So prices of yield instruments usually fall when Treasury yields rise. I am anticipating this exact scenario. I'm a bear on Treasury bonds. Prices should go down and yields should go up as the creditworthiness of the US government deteriorates. Right now, with the 10-year yield at 3.64%, investors are assuming that the future direction of inflation and budget deficits will remain under control. Treasury bond bulls will argue the following points about inflation, federal deficits, and the existing stock of Treasuries. I've listed the bullish consensus view in bold type. My responses, listed as the alternative view, will follow each consensus view: Consensus view on inflation: "High unemployment and low manufacturing capacity utilization will keep inflation fears in check. So those folks expecting inflation fears to push Treasury yields higher in 2010 are a few years early." Alternative view: Outside of the panic liquidation conditions of fall 2008 or the Great Depression, rising prices are hard-wired into the US economy. If investors panic once again and desperately seek to hold cash, the Fed can team up with spending addicts in Congress to create new US dollars in limitless quantities. The past two years have proven this out. The issue isn't whether the government can satisfy demands of investors looking to liquidate assets and hold dollars. As long as Treasury yields remain low, the government can create limitless amounts of new credit to satisfy investor demand for default-free government liabilities (Treasuries and paper money). Instead, the real risk facing financial markets over the next few years is whether investors will remain willing to hold cash and Treasuries at low yields. Cash has no intrinsic value beyond the belief that it can be exchanged for goods and services. The value of Treasury securities depends on investors' willingness to hold them, despite the near certainty that trillions in new Treasury securities will flood the market over the next decade. The high unemployment/low capacity utilization argument is theoretical, antiquated, and based on a fairly closed, manufacturing-oriented economy. In this theoretical economy, unemployed workers continually bid the price of their labor lower until supply and demand for labor reach equilibrium at lower prices. Today's US labor market does not work that way. The work force is very specialized. A laid-off automotive engineer is not likely to underbid the salary of nursing graduates for an open nursing position. Instead, those who have left the labor pool are collecting unemployment benefits without contributing to the aggregate supply of goods and services. When the claims on goods and services grow faster than actual supply, prices rise. The conditions for hyperinflation arise when an economy's productivity collapses and supply of government liabilities overwhelms demand (as confidence in the value of those paper government notes collapses). The Federal Reserve promotes the "low capacity utilization" case for low inflation so it can keep subsidizing the wounded banks with easy money. But the market could lose confidence in the Fed's theory if the CPI remains stubbornly high at the same time as unemployment remains high. The market would express this view by selling off long-duration Treasuries, which increases yields. If this happens, the Fed will have to tighten policy to restore the market's confidence in the integrity of paper dollars. Fed tightening would lead to a reacceleration of the unwinding of the commercial real estate bubble. Consensus view on Treasury supply required to fund budget deficits: "Even though US household savings may absorb just a few hundred billion in Treasuries in 2010, foreign investors and US banks will buy enough to keep yields from rising." Alternative view: Several sources estimate that the US Treasury must auction roughly $2.5 trillion in new securities in 2010. Some of the proceeds will retire maturing securities, while the balance will finance the budget deficit. The majority of the Treasury securities auctioned in 2009 were bills with very short maturity. The average interest rate paid on the Treasury bills auctioned over the past year is roughly 1%. But recently, Treasury auctions have been weighted more toward the longer maturities. Supply could overwhelm demand, causing prices to fall and yields at auctions to rise. Because banks are choosing to defend their souring bubble-vintage loans, and writing them off slowly over time, they won't have the capacity in the "hold to maturity" section of their balance sheets to absorb as many Treasury securities as the market expects. If banks had flushed most of their bad loans off their balance sheets in 2009, they would have capacity to absorb perhaps hundreds of billions in Treasury securities in 2010. But they didn't. There is a scenario in which domestic demand for US Treasuries could exceed new supply in 2010: another stock market meltdown similar to the one in late 2008. If enough investors flee stocks in a panic and invest the proceeds into Treasuries, yields could go down. But considering that the government has committed its balance sheet to bailing out the financial system, that scenario is unlikely. More likely is a scenario in which investors question the integrity of the US balance sheet. The way to do that is to sell Treasuries. This scenario would be negative for the stock market, likely sparking the next leg of the secular bear market - a leg that involves several years of the S&P 500 trending gently lower under a rising interest rate environment. But it wouldn't likely involve a 2008-style panic liquidation of stocks. Consensus view on the existing stock of Treasuries held by foreign investors: "Year after year, Treasury bears predict that foreign appetite for US Treasuries will weaken, but they keep buying. Foreign central banks will maintain their appetite for Treasuries because they have to keep their currencies cheap or pegged to the US dollar." Alternative view: Foreign investors must be willing to hold Treasuries at a yield that compensates them for the risk that inflation and interest rates might go up in the future. If these investors fear that future inflation, interest rates, and deficits will remain dangerous, they won't buy more Treasuries until yields rise to higher levels. A financial market that's evolved to a state at which it requires a perpetually growing inflow of new money to remain stable is a Ponzi scheme. The market for tech stocks in 2000 and real estate in 2006 had evolved into a Ponzi. Those who argue that foreign creditors will never sell Treasuries because it's "not in their best interest" should explain why investors sold tech stocks or housing when they were in bubbles. Surely, it wasn't in the best interest of tech bulls to sell. Selling meant prices would fall, thereby damaging the value of tech stock positions. But they sold aggressively, because they perceived it to be in their best interests. The situation of foreign creditors holding an unpayable mountain of debt of a trading partner is a classic "prisoner's dilemma." A prisoner's dilemma is a situation in game theory in which two parties might not cooperate even if cooperation is in their best interest. China and Japan might both conclude that buying more US Treasuries is not in their best interest. If they both stop buying at the same time, prices will fall and yields will rise. This scenario, by the way, is the reason that the responsible American public is opposed to Keynesian deficits as far as the eye can see. Just because Keynesian pro-deficit policies plug a theoretical hole in "aggregate demand" doesn't mean they are sustainable or wise. The public understands that Keynesian deficits are unsustainable. The cumulative effects of these deficits - which are never offset by surpluses during the good times - ultimately destroy confidence in both the government bond market and the currency. When the Japanese government hits the debt wall in the next five years and Japanese bond yields spiral upward, it will prove the foolishness of Keynesian policy. Here is where the existing stock of US Treasuries comes into play. Japan already owns $750 billion worth of Treasuries. When the Japanese government hits the debt wall and yields rise, the Bank of Japan will likely print new yen to fund the government. If so, the value of the yen could collapse, which would force the Japanese Ministry of Finance to sell some of its $750 billion in US Treasuries in order to defend its currency. It remains to be seen how long the government and the central bank can keep savers involved in this Ponzi scheme. This scenario - if Japanese savers abruptly lose confidence in their government's ability to service its massive debt load with taxes and bond market proceeds - is how Japan could shift quickly from deflationary conditions to hyperinflation. Japan is several years ahead of the US in the transformation of its government bond market into a Ponzi scheme, so we should consider it a canary in the coal mine. Aside from Japan, the appetites of two other huge Treasury investors are waning. The Chinese are rolling their maturing notes and bonds into buying shorter maturity bills. And the Social Security trust fund is not far from being in the position where it's a net seller - rather than a net buyer - of Treasuries. With unemployment stubbornly high, less payroll taxes are flowing in. With lower payroll tax inflow in 2010, the trust fund has less of a surplus to invest into Treasuries. When demographics switch the trust into a deficit position, it will become a net seller, rather than a buyer, of Treasuries. All of these factors argue convincingly for rising Treasury yields in 2010 and 2011. The consensus does not seem concerned about these factors. As of Jan. 20, the FTSE NAREIT Equity REIT Index yields 3.72%. This is roughly equal to the 3.64% benchmark 10-Year Treasury yield. Over the past 20 years, the average spread of the NAREIT index over Treasuries was 100 basis points, or 1%. Removing the influence of the 2005-2007 REIT bubble takes the historical average spread closer to 300 basis points over Treasuries. So not only are REIT valuations at risk from rising Treasury yields, they're also at risk from rising spreads over Treasuries. Considering that REITs are in a prolonged post-bubble environment, it's reasonable to assume that REIT spreads over Treasuries will rise to 300 basis points or more. Assuming both factors - rising Treasury yields, a rising spread of REIT yields over Treasuries - the REIT index could easily fall 50% from current levels. Regards, Dan Amoss for The Daily Reckoning --- Dan Amoss's Strategic Short Report Uncovers... --- Hidden Government "100-F Documents" That Let You Predict Which Stocks Will Go up or Down Discover how one small group of Americans uses government-mandated "100-F Documents" to easily predict gains or losses for any household- name stock in America... On at least 58 different dates, each year... And how you can now use these same "secret" documents to post returns as high as 400-600% over the weeks ahead. Learn How Here. --------------------------------------------------------------- And now to Bill who has today's reckoning from Baltimore, Maryland... Got money? You might find it hard to hold onto. Americans with money are caught in a vise. On the one side is the de-leveraging economy. On the other is the government. The depression squeezes everything - asset prices, businesses, earnings. And it's going to be with us for years - no matter what the papers tell you. Get ready for a 20% decline in stock prices, says our old friend Marc Faber. Another analyst puts the current P/E at 22...also implying a loss of about 20% just to get down to 'normal' levels. But "this isn't a normal environment," says a senior analyst at Ned Davis Research. Well, it's normal - for a depression. When word gets around, you'll see stocks lose ground. Housing will probably go down in price too. Meanwhile, over on the other side of the vise, Mr. Obama says he wants to raise taxes on the rich and on businesses by $1.9 trillion. Let's see. We'll make some guesstimates. There are about 100 million families in the US. Of those, about half are net taxpayers. And the top 10% are said to own half the wealth in the US and already pay 66% of its total taxes. Looks like they're going to get whacked again. Each of the 'rich' families will pay nearly $200,000 more in taxes. The idea is to make the tax system more 'balanced,' says the president, by taking more money from the people who pay the lion's share of US taxes...and giving it to people who don't pay anything. Here's a comment from Chris Edwards of the Cato Institute: "President Obama has introduced his budget for next year. He proposes that the government spend $3.83 trillion in fiscal 2011. To put that number into context, let's take a trip down memory lane. "Pres. George W. Bush...came into office when annual federal spending was $1.86 trillion. He proposed to increase spending at a healthy clip, rising to $2.71 trillion by 2011. "Bush and his team started blowing their budget almost immediately. They kept spending more and more - wars, a giant new homeland-security bureaucracy, a big-government response to Katrina, the prescription- drug bill, doubling K-12 education spending, big pay raises for federal workers, financial bailouts, and so on. I can't think of a single crisis that occurred on President Bush's watch that the Bush-Rove team didn't have an interventionist and big-spending response to. "In Bush's last year, FY2009, the government spent $1 trillion more than the Bush-Rove team had originally planned. It is true that 2009 spending included $112 billion for the Obama stimulus bill, so let's take that out. With that adjustment, the Bush-Rove team ended up spending $916 billion more annually by 2009 than they had originally planned. Note that the wars in Iraq and Afghanistan cost only about one-fifth of that 2009 excess spending amount. "Then Obama comes into office and turns out to be Bush on steroids with respect to federal spending. Obama is calling for spending $3.83 trillion in 2011, or $1.1 trillion more than the federal budget nine years ago had promised. That's a 41 percent forecasting error. "The lesson from all this is that an administration's promised spending beyond the first year is meaningless. Obama is proposing a freeze on a very small part of the budget, for example, but his budget plan next year will likely find reasons to break that promise. It scares the hell out of me that federal spending down the road could be 41 percent higher than even the huge increases projected by Obama..." We understand the larceny of the tax increases. What we don't understand is the economics. The idea of a $3.8 trillion budget is to stimulate the economy. The Obama team knows as well as we do that this 'recovery' is mostly a mirage. Without jobs...and housing...you can't expect real growth. Monetary stimulus has failed. Mr. Bernanke supplies the banks with all the free money they want. All they do with it is pay themselves bonuses. What more can Bernanke do? Rates are already at zero; they can't go lower. That leaves fiscal stimulus. "Spend more money!" That's what economists such as Nobel prize winner Paul Krugman, The Financial Times' lead economist Martin Wolf, and Japan expert Richard Koo are whispering in Obama's ear. Spending supposedly boosts sales and creates jobs. But if you're just taking money from one pocket and putting it another, what's the point? There is no net increase in spending power. Still, economists argue that the rich don't spend their money; they save it! And we know what an awful thing saving is... Taking money from 'the rich' actually retards a real economic renaissance. The rich are the ones who consume the most...because they have the most to spend. More importantly, they're the ones who fund the small businesses that do the hiring. Banks won't take a chance. It's the relatives...and 'the rich' themselves...who put their money on the line. Either someone forgot to explain this to the Obama administration or they just don't care. In Washington, politics trumps economics every time... And now, both politics and economics are putting pressure on Americans with money... --- Lifetime Income Report Presents --- Enroll today and immediately start collecting "pension paychecks" every 15 days, for the rest of your life... Retirement, Plan B: Without doing a single moment's work, now you can legally sneak onto the "payroll" of nearly 1,000 of America's best companies... And collect a regular "Plan B Pension" check as often as every 15 days... At any age and for as long as you like, even after you've already retired... With nonstop annual incomes running as high as $120,000 or more... Grab Your Copy of This quick Step-by-Step Guide Here. --------------------------------------------------------------- And more thoughts... Here's another mystery: Homeowner defaults. Not that there are so many...the mystery is why there are so few... In Nevada, for example. Two out of three homeowners are underwater...which is hard to do in the desert. Some of them owe hundreds of thousands of dollars on something that doesn't exist anymore - the equity on their houses. Still, most of them continue making mortgage payments. What gives? It's a case of "asymmetrical ethics," says The New York Times. Lenders don't hesitate a minute to maximize their earnings - using every tool available to them and every trick in the book (including some tricks that have never been published). They default whenever it suits them. But homeowners? They plod along. Maybe they think their house will come back in price. Maybe they think they'll suffer some awful penalty if they default. Maybe they are just too proud and too honest to take advantage of the non-recourse mortgage provisions. So, they keep paying. But for how long? Mortgage rates are based upon past behavior. In the past, people regarded mortgage payments as an inescapable, moral obligation. You paid as long as you were able. It won't be long before the ethics of Wall Street catch on all across the country. Gaming the mortgage system will become as common as signing up for food stamps. When people see that house prices won't go back up...and when they see their neighbors shedding hundreds of thousands of dollars' worth of mortgage debt - and getting away with it - they won't be far behind. "You've been out of the country for a long time. Maybe you notice it. Most people don't." The subject was hamburger. At a hamburger joint in Rockville, Maryland, the server had asked: "How would you like that burger cooked?" "Medium rare," we replied. "I'm sorry. We don't do medium rare," was the reply. Why doesn't a restaurant cook a hamburger the way the customer wants it cooked? Recently, in Baltimore, we ran into the same sort of thing. At the Peabody Court hotel, we asked the desk clerk if he could have someone pick up our laundry. We had left it neatly on the bed, with a laundry slip all filled out. "You have to bring it down here," was his reply. "What?" "You have to bring it down yourself." "What? Isn't this a hotel? Aren't you in the hospitality business?" Our protests were useless. They wouldn't pick up the laundry because they had a policy against it. The policy was designed to protect them against customers who tried to take advantage of them by claiming laundry had not been returned. Now, a guest has to bring his dirty laundry to the front desk and have it inspected! The restaurant had similarly taken measures to protect itself from customers who might get sick from uncooked beef. As at the hotel, the precautions are for the benefit of the business, not the customer. "Oh...and I heard something on the radio..." we continued with our conversation with a colleague. "There is a proposal in Maryland to make it a criminal offense to smoke in a car in which a child under the age of three is riding. Already, you can't smoke in bars or restaurants. There doesn't seem to be any limit to the improvements a legislature can make, does there?" "Yes. And the most amazing thing is that people will go along with anything. There is no resistance. Nobody thinks anymore, they just follow silly rules and procedures. I was just on a trip outside the US with a group of older people. We traveled around other countries with no problem. But coming back to the US was a hassle. They carefully searched all these old people...as if they really thought these folks posed a threat to homeland security. "This war against terror probably conditioned Americans not to question authority. It's been going on for 9 years now. As far as I can remember there were only two incidents in all that time...and they were almost comic. One guy set his underwear on fire...the other lit his shoes..." Regards, Bill Bonner, for The Daily Reckoning --------------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com   The Daily Reckoning - Special Reports: Gold: The Truth About Gold Fiat Currency: Using the Past to See into the Future "THE GREAT AMERICAN RECOVERY RP-OFF" Brace yourself for what's about to go down as the BIGGEST FINANCIAL SWINDLE in world history.

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