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The Daily Reckoning | Wednesday, July 28, 2010 Debt up, yields down...and other nonsensicals in the marketplace, Watching debt, cashing up and buying gold on dips, Plus, Bill Bonner on outsiders and their fantastically half-baked ideas... Reducing Spending Not in the Feds' Plans Why the government hates it when people do the right thing Bill Bonner Reporting from Paris, France... Yesterday, the rally on Wall Street slowed down a bit. The Dow rose 12 points. Gold had a bad day - down $25. We had guessed that gold would be going down. But it is still too early to detect a real trend. For the moment, the financial markets and the economy are going in different directions. The stock market is signaling a boom. The economy and gold are signaling a bust. We'll have to wait and see which direction prevails... In the meantime, had a seer come to us a couple of years ago with a tale of back-to-back US deficits totaling $3 trillion over two years, his credibility would have been in doubt. Had he also foreseen US Treasury debt at record low yields - at the same time - he would have had no credibility at all. One of the surest things we thought we thought we knew back then was that the government could not simultaneously run huge deficits and borrow cheaply. It was one or the other; that was all there was to it. It turns out that Dick Cheney was right all along. Deficits don't matter. At least, they don't matter until they do matter. And they don't matter right now. Bloomberg: For all the criticism of record budget deficits, President Barack Obama can take comfort knowing that for the first time in half a century, government bond yields are declining during an economic expansion and Treasury Secretary Timothy F. Geithner is selling two-year notes with the lowest interest rates ever. The combination of record-low yields on two-year notes, 10-year rates below 3 percent and a deficit projected to surpass $1.4 trillion for a second consecutive year is a signal that the bond market is less concerned with government spending than with getting the economy back on track. The last time yields were this low as the economy expanded was in 1955, when Ray Kroc founded McDonald's Corp. and Bill Haley's 'Rock Around The Clock' topped the music charts. The 10-year note yield averaged 2.65 percent that year, according to monthly data compiled by the Fed, while the economy grew 6.4 percent, consumer prices for the year declined 0.4 percent and the government ran a fourth consecutive budget deficit. Why have yields fallen so much? Because the economy is not recovering. Investors look for a safe place to put their money. Bloomberg continues: "Expectations of growth over the next couple of years have indeed come down," Alan Blinder, former Fed vice chairman, and economics professor at Princeton University, said in a telephone interview. "There is still plenty of fear out there in the world financial markets, which has investors all over the world scurrying into Treasuries, even though they get paid very little." We opined - without doing any research on the subject - that Harley Davidson had probably peaked out. Only old men ride Harleys. The young prefer a different style of bike. We guessed that it was time to sell the stock. Naturally, the company's earnings have soared since then. But not because of increased sales. Instead, like the rest of corporate America, Harley is learning to earn more money without selling more merchandise. The New York Times has the story: Motorcycle sales are falling in 2010, as they have for each of the last three years. The company does not expect a turnaround anytime soon. But despite that drought, Harley's profits are rising - soaring, in fact. Last week, Harley reported a $71 million profit in the second quarter, more than triple what it earned a year ago. This seeming contradiction - falling sales and rising profits - is one reason the mood on Wall Street is so much more buoyant than in households, where pessimism runs deep and joblessness shows few signs of easing. Many companies are focusing on cost-cutting to keep profits growing, but the benefits are mostly going to shareholders instead of the broader economy, as management conserves cash rather than bolstering hiring and production. Harley, for example, has announced plans to cut 1,400 to 1,600 more jobs by the end of next year. That is on top of 2,000 job cuts last year - more than a fifth of its work force. Everyone is doing the right thing. Households are reducing spending. Business is reducing its costs. GDP growth is falling and investors are taking shelter in Treasury debt. So what's the problem? Well, the feds can't bear to see people doing the right thing. They want them to do the wrong thing - that is, they want them to spend money they don't have on things they don't need. Why? Because it makes the economy look good...and makes them look like they know what they are doing. It's all hokum and folderol, dear reader...all hokum and folderol...as guest columnist, David Galland, explains below... The Daily Reckoning Presents Hooray for the Economic Recovery!...of 2016 David Galland Last week, the price of gold again broke below its new base at $1,200, and the US stock market was again under strong pressure, due to a confluence of fears, most of which point to a deflationary double-dip. The fears were fanned by disappointing second quarter results, by the latest CPI reports that show inflation continuing to moderate, and by yet another poll revealing faltering consumer confidence. The market is also spooked, no doubt, by notes from the latest Fed Beige Book that make it clear that the Fed is (finally) beginning to understand the entrenched and endemic nature of this crisis. While the notes are written in shamanic double-speak, the point is clear: members of the Fed don't expect the economy to get back on track until 2015 or 2016. "Participants generally anticipated that, in light of the severity of the economic downturn, it would take some time for the economy to converge fully to its longer-run path as characterized by sustainable rates of output growth, unemployment, and inflation consistent with participants' interpretation of the Federal Reserve's dual objectives; most expected the convergence process to take no more than five to six years." The simple reality the Fed is waking up to is that the structural underpinnings of the economy are damaged beyond any quick or easy fix. That's because until the excess and/or bad debts are wrung out of the system - either through default or raging inflation - there's no chance of any sustainable economic recovery. Each new government initiative - the latest being financial reform - that doesn't decisively address the debt, but rather tightens the government's around private enterprise, only serves to delay or prevent economic revival. And so each new day will bring more distress and bankruptcy to homeowners, businesses, and banks. Pundits are fond of saying that things are never really "different this time around"... yet there is something truly unusual now going on. See if you can spot the disconnect in the following descriptions of the current economy. Record total debt. Record government deficits. Record trade deficits. Massive additional government debt financing required to keep the doors open and avoid reneging on social contracts directly affecting the quality of lives of millions of people around the globe - the US, Japan, and Europe especially. Near record-low interest rates. Anything strike you as out of place? The current setup with massive debts and low, low interest rates is like making an uncollateralized loan to a mere acquaintance at a very friendly, low interest rate. Then he comes back again for more, and more, and more. Because you live in a small town, you know he's putting the touch on a bunch of other people too. And because you know his loose-lipped accountant, you also know what his income is, and even what his total debts are - and it is blatantly obvious that he won't be able to repay his debts in a dozen lifetimes. So would you keep lending him money? And, if you did, would you do it at the same friendly interest rates? Not hardly. And therein lies the Twilight Zone-caliber disconnect in the world as we know it. In a recent conversation with my dear partner and friend of several decades, Doug Casey, he made the point that the situation today should only exist if the fundamental laws of economics had been suspended. Interest rates should be going up, but they aren't. Rather, they are bumping along at the very bottom of the possible range. In my view, this is testimony to the truly extraordinary lengths - involving trillions of dollars - that the US Treasury and the Fed have gone to in recent years. But they can only suspend the laws of economics for so long before the fundamentals again rule. And when that happens, the entire system could literally collapse. Not to sound dramatic, but it could happen almost overnight. As frustrating as it may be to all of us, the world is still locked firmly in the jaws of a powerful bear market. While the bear may loosen its bite now and again, it's really only temporary...to get a better grip. That being the case, it's worth remembering the single most important thing about bear market investing: it's very difficult. Or, put another way, it's hard to make a decent return without taking extraordinary risk. As Doug points out, in the current environment, everything - including commodities - is overvalued. And they are going to remain that way until they aren't. Maybe the Fed actually has it right this time, and the bottom won't be reached until 2015 or 2016? I wouldn't argue with that assessment. But what of the inflation we see as inevitable? And gold, in the interim? Let me quickly tackle the second question first. In any debt crisis, the foremost concern of creditors is to get paid back. Compared to that, returns on investment come in a weak second. In a sovereign debt crisis, the question of repayment is complicated by the fact that the debtors control the creation of the currency units that will ultimately be used for payments. Individual and institutional holders of US Treasuries, along with other assets amounting to trillions of US currency units, can see with their own eyes what's going on. To continue holding such large quantities of instruments denominated in these unbacked currency units - or those labeled "euros" or "yen" - is to risk being left with a lot of worthless paper as the governments try to repay debtors by creating the stuff, literally, out of thin air. And so these holders diversify their portfolios into alternative, and far more tangible, assets - gold and silver included. That is the fuel that has sent gold higher over the last ten years and that will keep it high - short-term corrections notwithstanding. It is, however, when the inflation from all the money creation starts to appear that we'll begin to see the shift into gold begin in earnest, and the price will really take off. When might that occur? Rather than trying to answer that question myself, I'll refer you to the latest, excellent edition of, Conversations with Casey, in which Louis James interviews Casey Report co-editor Terry Coxon on the outlook for inflation. Here's an excerpt... Coxon: All of the runaway deficit spending [by the US government] is not, in and of itself, inflationary. By spending borrowed money, the government does not increase the money supply... L: Ah. You're saying that out-of-control government spending isn't inflationary, but sets the stage for future inflation, when money has to be created to pay the government's debts? Coxon: What it does is create a political motive and economic need for inflation. These huge deficits may have slowed the recession that began in 2008, but to keep the recession from worsening, the Federal Reserve will have to prevent interest rates from rising for months or years to come. And to do that, it will have to start printing money to buy up debt instruments whenever the economy starts recovering, to keep interest rates down to levels that will not choke off the recovery. L: So more money creation will be necessary to keep interest rates low, but at some point, the foreigners holding dollars, believing it to be a sound currency, will have to get worried about all this dilution of the dollar - and that would tend to force interest rates up, as it will take more and more to convince those people to keep buying T-bills and such. Coxon: The world outside the US has become like a giant capacitor for US inflation. The charge that's building up is the accumulation of dollars and dollar-denominated assets in the hands of foreigners. When the outside world wakes up to the threat of inflation in the US, they will start unloading US dollars, which will suppress the dollar's value in foreign exchange markets, which will make prices of imports (including oil) go up, and that will be a separate vector feeding price inflation in the US. For now, the key is to get through this period in the best possible shape. That means watching your debt levels, keeping well cashed up, buying gold on dips, and, when you venture into investment markets, it's never been more important to understand what you are investing in and why. There's no need to chase anything - which means you have the luxury of building your portfolio over time, on exactly the terms you want. While it may sound contradictory, I think this is also a good time to learn more about speculating. In the simplest terms, a speculator risks just 10% of his/her portfolio in the hopes of receiving a 100% return. By comparison, most investors put 100% of their portfolio at risk in the hopes of getting a 10% return (actually, these days, most people would be happy with just 5%). In the case of the speculator, 90% of the portfolio can be largely kept in cash and gold. So, who's more at risk - the investor or the speculator? And where are the best speculations found today? Personally, I like energy, and I very much like bottom fishing in the junior gold sector. That's because there are some terrific Canadian junior exploration and mining companies sitting on large known deposits. But their share prices periodically fall back based on nothing more than investor emotion. That's called a buying opportunity. David Galland, for The Daily Reckoning P.S. For our best bets in this sector, check out a risk-free 3-month trial to the International Speculator - it's no coincidence that every single stock Senior Editor Louis James picked in 2009 has turned out to be a winner. Details here. Bill Bonner The Benefits of Being an Outsider Bill Bonner With the rest of today's reckoning... Paris is for lovers. We are sitting in a café in the 19th arrondissement, with a complete set of café furniture stuck upside down on the ceiling. In front of us, as we finish our Daily Reckoning, is a couple of young Japanese or Chinese. Good looking people. The man has a very distinctive look, with long hair and a chiseled face. Not knowing anything more about it, we would guess that he is a descendant of Mongol invaders who swept into China and set up a dynasty under Kublai Khan in the 13th century. He is a cross between Jackie Chan and Genghis Khan. She, on the other hand, has a prettier, softer, more civilized look, like the delicate court women found on Chinese paintings. What an ardent lover he is! He leans towards her. He kisses her. He strokes her shoulders and her leg. He is so full of life. So enthusiastic. It is hard not to like him. But she is being coy. It is not clear she really appreciates his attention. Maybe she is mad about something. Or, maybe she is thinking about something else...shopping...travel...or how she will pay her bills. Either he doesn't notice...doesn't care...or he is trying to win her over. Good luck to him! *** There are two kinds of people. There are the insiders and the outsiders. What makes the Vancouver conference particularly interesting and fun is that it is full of outsiders. Insiders are people who, literally, want to be inside. They are joiners. They are club members. They participate in community affairs and attend meetings. They know the right people and make easy conversation at dinner parties. They have the right ideas too, those that are socially acceptable. They get them from magazines and TV. If there were a crowd, the insiders would want to be in the middle of it. They are very alert to how to 'dress for success' and very careful to send their children to the right schools. Some are ambitious. Some are not. Some are leaders. Some are followers. But whatever they get in life they expect to get it by following paths laid out for them. But the people at the Vancouver conference are rarely insiders. They are often oddballs, eccentrics and free-thinkers. They tend to be original in their habits and in their dress. They went to universities no one ever heard of and followed career paths their parents warned them against. They can be excruciatingly bad company, because they tend to focus on narrow areas, noticing things that others miss...developing skills and interests that others avoid. They are always on the fringe...on the margins...on the edges of mainstream life. In short, they are Daily Reckoning readers! That is why it is a pleasure to meet them and hear their stories. One joined the army, learned radio communications, and went out on his own to build a technology company based on his own invention. Another bought up apartment buildings in Cleveland and sold them at the top of the bubble. One dropped out of high school. Another makes movies. "I went to college and studied engineering," said a man with a German accent. "Then, I came to the US. I didn't have any money. I didn't have any connections. So I looked for a job. This was many years ago, when you could still do things like this. After a couple of weeks, though, I was getting desperate. Because I was running out of money completely. So, I went into a bakery. The guy asked me if I knew anything about baking bread. I said 'sure.' All I knew was that I had lived above a bakery in Germany. I knew they started work early in the morning. But I figured I'd at least get a lot to eat before he realized I didn't know anything. He told me I could start tomorrow. "That afternoon, I went to the library and found a book on baking. I read it carefully. So, at least I knew what it was all about, in theory. But when I got to work, I didn't know how to operate the ovens or anything like that. And my boss saw I didn't know. So I told him... 'These are very different from the ovens we have in Germany.' "He pointed to the label on the machine - 'Made in Germany' - ha ha.... But we became good friends and we opened up a whole chain of bakeries." Outsiders often have strange ideas. But they always have good stories to tell. Regards, Bill Bonner, for The Daily Reckoning