D.C. Fiddles While the Economy Burns: What the Market is Telling Us

As the endless debt ceiling nonsense continues unabated this morning, the markets are telling an interesting story.  SPY (which represents the S&P 500) is down .75%, while TLT (ETF for 20-year treasuries) is up 1.34%!  What's going on?

The message is split.  If the current "Capital Hill Circle Jerk"© proceeds through Aug. 2 (only 4 days away!), the government will be forced into a partial shutdown: workers will be furloughed, parks will be closed, medicare and medicaid reimbursements may be held back, and social security checks may be reduced or delayed.  Certain to cause an economic slowdown, or maybe a double-dip recession!

Whether or not a deal is reached before "Tim Geithner Turns Into A Pumpkin Day", it's becoming more and more clear that real spending cuts are coming down the pike, and they'll hurt.  Contrary to Tea Party rhetoric, austerity is not good for the economy (at least in the short term).  So, regardless of the timing of a debt deal, this will exacerbate an economic slowdown.

On the other hand, the sturm and drang over potential default has been overdone.  Interest payments are not due till August 15, nearly two weeks after Geithner's spending cuts kick in.  Well before that time, the entire country will be in a lather, the political pressure will be too much, and a deal will certainly be made.  Additionally, if Uncle Sam tries to stiff bondholders, expect the courts to issue an injunction preventing default, as I suggested here. Treasuries are gaining further strength because the market anticipates economic weakness, as mentioned above.

So, I was wrong a few weeks ago.  Buy treasuries here. Tweet

Dr. Doom Hits the Chinese Nail on the Head

I don't usually agree with Nouriel Roubini but he nailed this one.  A sample:

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Roubini's  post vividly illustrates some of the reasons I'm quite bearish on China.  How can the whole world be so excited about a command economy?  Has there ever been a centrally-directed economy that creates long-term prosperity?  Tweet

It's Clear: Default on Debt is Unconstitutional

If all else fails, and DC can't agree on a formula to lift the Debt Ceiling, the U.S. Constitution will save us again.

Section Four of the 14th Amendment says that “[t]he validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”   Seems pretty clear to me--Congress can't interfere with paying interest on the debt.

Who has standing to file suit to enforce this?  Anybody that owns Treasuries and doesn't receive scheduled interest.  When would they file suit?  If the Administration announces plans to suspend interest payments, I would think that major bondholders (mutual fund companies, rich people, maybe even the Chinese government) would apply for an injunction to keep the cash coming.  They'd probably choose a pro-business venue like the 8th Circuit Court.  The plaintiffs would win, then the appeal would be fast-tracked to the U.S. Supreme Court, where the plaintiffs would win again.

So, the government would be forced to keep sending out interest payments while stiffing Social Security recipients, U.S. Servicemen, federal employees, etc. etc. etc.

IF this highly unlikely result comes to pass, it would be loaded with irony (the most delicious taste on earth, IMHO).  The Tea Party base, mostly made up of old white folks, would be sputtering with rage.  The President would ride this "defeat" to easy re-election, as he can easily paint himself as the guy who tried to keep the SSS (Social Security Spigot) turned on.  The Supreme Court would render the Debt Ceiling null and void, permanently ending revivals of the recent silliness...and permanently prohibiting Congress from using this lever in the future (tasty, no?).  And last but not least, the People's Republic of China may defeat the U.S. House of Representatives in front of the U.S. Supreme Court (it just doesn't get any better then that!).

So Bill Long, Jeff Duncan, and the rest of you newly-elected Representatives--try reading the Constitution some time, instead of just carrying it around. Tweet

Hey, D.C.: Would Dow Down 1000 Get Your Attention?

As I write this, Congress and President Obama are engaged in a high-stakes game of chicken on the debt limit.  Congressional Republicans (mostly Tea Partiers) refuse to increase the nation's credit limit without major spending cuts.  Further, they've rejected any tax increases as a way toward fiscal sanity.

The media is in an absolute tizzy over the possibility of default.  Will interest rates skyrocket?  Will our economy grind to a halt?  Will social security checks and Medicare reimbursements be scuttled?  And what about the Armed Services?  Will our brave fighting men get paid?

Interestingly,  the markets have largely yawned over the whole thing.  US Government bonds (after a week-long plunge on the heels of QE2 expiration at the end of June) have rallied back to where they were in mid-June.  The stock market has done it's usual midsummer random walk/drunken stagger.  In short, the markets think that a deal will be reached (after each side makes a big show of storming out of meetings, a few Tea Party nuts threaten to let the country default, and the Congressional Cots are dusted off for an all-nighter).

But, what if the markets are wrong?   I know, I know, the markets are always right.  But what if the Tea Partiers really are crazy enough to let the country default?  What if the Dennis Kucinich Democrats decide to go to the wall over entitlement cuts?  What if we really get close to Tim Geitner's Aug. 2 drop-dead date without a deal?

As this possibility dawns on Wall Street, expect yields to rise on all fixed income (corporates will follow Treasuries).  Slowly at first, then more vigorously.  The stock market will follow suit.  It could get really ugly.

Then, after the Dow is down about a thousand points or so, and TLT down 10, The Washington Wankers will finally get it!  It's time to get a deal done.  Because if they don't, nobody's getting re-elected. Tweet