Although the crisis in America will probably come last because of our global status, at the end of the day we are still borrowing whatever we cannot raise in revenue. This makes us no different from Greece. We just announced the largest monthly budget deficit in history, which demonstrates that we still have not attacked the disease. We find ourselves in a very precarious position because it now takes about 4 years to match the national debt it took 224 years (until 2000) to accumulate.

The real serious debt problems are straight ahead. Under the Federal pension system (FERS), pensions are based on: 1) the average of your highest 3 years of pay, and 2) your years of service. A higher proportion of government employees happen to be in higher paid fields such as law. (As a side note, this is why the SEC is so damn incompetent- it is an agency filled with lawyers. Who thought up the genius idea of having lawyers with no experience in finance regulating financial markets? Our government is a lot stupider than you think). Anyway, since public sector workers are well-paid, their pensions will be very generous under the current system.

Now let’s think about the wave of people who are eligible to retire. In 2007, 18% of Federal employees were eligible to retire; by 2016, that number goes to over 60%. Hmm. Is a pension crisis perhaps on the horizon? Don’t worry, your leaders will tackle the crisis head on– in 2016 when it is too late.

This crisis is going to wipe out retirees if the correct actions aren’t taken. Stay the hell out of government bonds and buy stocks. The government only has one option- the printing press- and they are willing to use it. Bernanke has stated in previous papers that he would not raise interest rates to counteract an economic slowdown created by oil shocks. Instead he will inflate, inflate, inflate. This is the reality we face today.

But Stocks Are Rising!

The mainstream media basically has no clue what they are talking about. They are like little children who try to find any data points that corroborate their predetermined conclusions. Stocks are rising so the economy must be recovering. Never does it cross their mind that perhaps we are seeing the beginning stages of severe inflation. At the end of the day, I cannot blame them- their knowledge of history is very small. People always misinterpret the early stages of inflation as a boom. Just take the example of Frau Eisenmenger, an Austrian who lived through their hyperinflation in the 1920′s, who wrote:

“Speculation on the stock exchange has spread to all ranks of the population and shares rise like air balloons to limitless heights.”

Sound mildly similar to the situation we face today? Eisenmenger wrote this before things got really bad in Austria. People saw stocks as a hedge against inflation, especially because of the composition of stocks back then. If you look at the historical accounts, tangible assets were in demand, not government paper. The Weimar Republic actually had full employment while their economy was imploding. Consumer spending was robust because people were trading in paper they knew was being depreciated for real goods and services. If the mainstream media were analyzing conditions back then, surely they would be calling it a “green shoots” economic recovery. There is a reason the mainstream can never see a crisis coming- their analysis is very flawed.

This is not the time to go 100% short stocks just because you are bearish on the economy- there are other factors at play. Stocks will rise because the big money will be trading their government bonds for stocks. Want proof? Look no further than Bill Gross, manager of over $1 trillion at PIMCO, who says to stay out of government debt. Make no mistake about it, the smart money is getting the hell out of government bonds. You should be doing the same.

Source: Record Budget Deficits, Pensions Coming Due

That government projections are not worth the price of the paper (especially not in today’s dis-disinflationary environment) they are printed on is no secret. As Zero Hedge recently demonstrated the margin of error in the most recent budgetary prediction can only be classified as insane. We wrote: “On February 28, 2001 George Bush said this about his 2002 Budget: “It will retire nearly $1 trillion in debt over the next four years.” Instead, US debt, which at that point was $5.7 trillion, rose to $7.7 trillion. $3 trillion rounding error? Also in the same budget, Bush predicted a $5.6 trillion surplus over the next ten years, which would wipe out all of America’s debt by 2011. The latest debt figure was $14.1 trillion. A $14.1 trillion rounding error, or a nearly five fold increase in “rounding errors” in a decade.” So that’s debt, what about budget surplus and/or deficit projections? It’s not any prettier. And courtesy of the NYT we can now see this in an easy to comprehend animation. Following the jump readers can see just how endlessly upward biased projections tend to almost without fail deviate with reality (and unemployment rates as well). The best indication: the 2012 projection to the 2008 budget forecast callsed for a surplus. Now we are expecting a massive deficit. So why do we listen to these monkeys with typewriters again?

Ful animation after the jump:

On the heels of U.S. President Barack Obama’s State of the Union address – during which the commander in chief highlighted the need for investment in innovation – a steep federal budget deficit projection yesterday (Wednesday) showed the harsh reality of the U.S. government’s spending spree.

In the Congressional Budget Office’s (CBO) economic outlook report, the nonpartisan body estimated the budget deficit would reach $1.5 trillion in 2011, or 9.8% of gross domestic product (GDP). The report cited the Bush-tax-cut extension, low production, and a weak labor market as key factors for reducing revenue, increasing spending and pushing the deficit higher in fiscal 2011.

This year’s federal budget deficit is up from $1.3 trillion in 2010 and $1.4 trillion in 2009. The deficits, when measured as a percentage of GDP were the largest since 1945, reaching 8.9% in 2010 and 10% in 2009.

The CBO said that GDP would grow 3.1% in 2011, but revenue growth will continue to move at a sluggish pace due to continued policies like tax cuts and unemployment benefits extensions. While 2011 government spending for financial crisis issues like the Troubled Asset Relief Program (TARP) is winding down, other outlays like Social Security, Medicare, and Medicaid will continue to grow.

It’s common for the government to engage in deficit spending after an economic downturn to breathe life into an ailing economy. But Money Morning Contributing Editor Martin Hutchinson said a deficit over $1 trillion this far into recovery mode is a red flag.

“The fact that the 2011 deficit has moved from $1 trillion to $1.5 trillion in the third year of recovery is very worrying,” Hutchinson said. “As output recovers, revenues normally increase and expenses decline and the budget moves toward balance. Thus each year of $1 trillion-plus deficits is more worrying than the last.”

Hutchinson said the effect on concerned markets of a growing government spending imbalance is similar to the European debt crisis.

“At some point the bond markets will panic, and we will become Greece – but there’s no EU to bail us out,” Hutchinson said.

Hutchinson highlighted the problems with President Obama’s State of the Union message in yesterday’s Money Morning issue with his article, “State of the Union: Why You Should Fear America’s ‘Sputnik Moment’.” He said the president’s goal to freeze domestic spending is flawed because it’s based on “grotesquely bloated budgets of 2010-2011,” offering only “windy rhetorical support” to the deficit commission, instead of useful suggestions.

“Obama last night had specific ideas of how to spend more money, but nothing specific on how to cut back,” Hutchinson said.

While President Obama asked Congress to rein in federal spending, he also proposed more investment in education, infrastructure and renewable energy. Republicans have criticized President Obama’s expansive use of the word “investment” – especially in cases where it’s clearly a euphemism for “increased spending.”

House Republicans, who gained control in November’s midterm elections, will be a roadblock in the president’s investment plans, as they aim to significantly cut government spending in 2011.

“Whether sold as ‘stimulus’ or repackaged as ‘investment,’ [the Democratic leadership's] actions show they want a federal government that controls too much; taxes too much; and spends too much in order to do too much,” Rep. Paul Ryan, R-WI, said in the Republican response to the State of the Union address.

But even with cuts, the country is bound to see some spending initiatives gain approval, with their price tags tacked on top of borrowing that is nearing the debt limit of $14.3 trillion. Hutchinson said Americans can expect to see talk of a value-added tax as the government hunts for a way to cover its debt.

“[I]t’s the one real revenue spinner, at roughly $50 billion per percentage point per annum. A push for it will certainly be made immediately in 2013 if Obama is re-elected, and maybe before,” said Hutchinson.

President Obama will submit his budget request for fiscal 2012 in the second week of February, which will provide a more detailed outline of fund allocation for the coming year.

Further CBO estimates for the years after 2011 showed a decline in the federal budget deficit and its percent of GDP. The CBO projected a $1.1 trillion deficit in 2012, $704 billion in 2013 and $533 billion in 2014, representing 7%, 4.3% and 3.1% of GDP, respectively.

But the CBO noted that its projections understate the federal budget deficit should the government extend many current policies beyond their expiration dates. It estimated that if many of the recently extended tax cuts remained in force, and Medicare payment rates were held constant, debt held by the public would reach 97% of GDP by 2021- the highest level since 1946.

The CBO said to prevent debt from reaching record levels, the government would need “to substantially restrain the growth of spending, raise revenues significantly above their historical share of GDP, or pursue some combination of the two approaches.”

Of course, a more a more balanced budget that could drastically reduce public debt and the federal deficit is hardly in the immediate future, says Hutchinson.

“We should probably expect the deficit to remain about $1 trillion until something really serious is done about it,” Hutchinson said. “And I don’t see that happening with the current combination of forces.”

The CBO also projected that inflation would remain low through 2012, and average no more than 2% a year through 2016. The unemployment rate, currently at 9.4%, is expected to fall only to 9.2% in 2011 and 8.2% in 2012, but will hit 5.3% in 2016, near the CBO’s 5.2% “natural rate” of unemployment.

“Inflation is definitely going up, and will be much higher than 2% in 2012, rising sharply thereafter until there’s a new Fed,” the CBO said. “Unemployment may get back to 5.3% with good policies, but there’s a problem in the long-term unemployed, who may become unemployable – far more of them than in previous cycles.”

Hutchinson said the country faces a high chance of another economic crisis that will erase any short-term improvement in the unemployment rate.

“The financial sector has not deleveraged post-crash and is now extended again.” Hutchinson said. “I expect another crisis well before 2016.”

News and Related Story Links:

• Money Morning:

  State of the Union: Why You Should Fear America’s “Sputnik Moment”

• Congressional Budget Office:

  The Budget and Economic Outlook: Fiscal Years 2011 to 2021

• The Wall Street Journal:

  Budget Deficit Is Expected to Hit $1.5 Trillion

• The Wall Street Journal:

  Text of Rep. Ryan’s Republican Response.

• Money Morning:

  What Do You Think of President Obama’s 2011 State of the Union Address?

No surprise: the projected deficit just went up by another half a trillion: “For 2011, the Congressional Budget Office (CBO) projects that if current laws remain unchanged, the federal budget will show a deficit of close to $1.5 trillion, or 9.8 percent of GDP.” This is up from $1.07 trillion: a very small margin of error there. But don’t worry – like true Keynesians the CBO expects that future deficits will have no choice but to go down: “The deficits in CBO’s baseline projections drop markedly over the next few years as a share of output and average 3.1 percent of GDP from 2014 to 2021. Those projections, however, are based on the assumption that tax and spending policies unfold as specified in current law. Consequently, they understate the budget deficits that would occur if many policies currently in place were continued, rather than allowed to expire as scheduled under current law.” So between 2010′s $1.3 trillion, 2011 $1.5 trillion, and 2012′s revised $1.1 trillion, we have $3.9 trillion just in deficit costs to plug. And as Zero Hedge has repeatedly demonstrated the actual debt to be issued is usually about 33% higher than the deficit funding need, meaning that over the next 3 years the US will need to issue about $5 trillion in debt. Which means further debt monetization is guaranteed as foreign investors have now fully withdrawn and the Fed is all alone in gobbling up every dollar in gross issuance. QE3 is guaranteed and we are stunned that the market continues not to realize this.

From the release:

Chart 1: Cumulative US Individual Income tax revenues and debt issuance. Since the failure of Lehman, through November 30, 2010, the US government has issued $3.8 trillion in debt, and collected $3.6 trillion in tax receipts. Uncle Sam continues to fund over 100% of every dollar received from taxes with his own credit card, which is somehow still stuck at an APR of about 2%.

Chart 2: The same as above, but also showing the cumulative differential between the two metrics. We fail to observe any green shoots, or any improvement in the cumulative delta.

Chart 3: While the debt to tax collection metric is deplorable, what is far more scarier, and has very profound implications for future US debt, is that the cumulative debt over deficit differential not only continues to rise, but has hit an all time high. Forgive us if we laugh in the faces of all those who claim that rising tax revenues are a certain indication of economic improvement. Nothing could be further from the truth: the only “improvement” is short-term economic stimulus (with an ever declining half life), purchased on Uncle Sam’s credit card. Should the recent acceleration in interest rates higher persist, we expect that very soon the Uncle Sugar APR will no longer be quite as attractive as it has been during this period of drunken sailor borrowing.

And if you are not scared enough by the above figures, here is Bill Buckler of the Privateer fame’s condemnation of what anyone with half a brain realizes is pure, unadulterated fiscal lunacy (dictated in no small part by the same people at Goldman who are now in charge of monetary policy as well):

Before fiscal 2008, the US Treasury had only run an official deficit above the $US 400 Billion level once – in 2004. In the three years between 1998 and 2000, the Treasury had even claimed to have run budget SURPLUSES, even thought its debt climbed throughout the period.

• In fiscal 2008 – the official Treasury deficit was $US 438 Billion
• Ten weeks into fiscal 2009 – the Fed cut its controlling rate to 0.00 – 0.25 percent
• In fiscal 2009 – the official Treasury deficit was $US 1.42 TRILLION
• In fiscal 2010 – the official Treasury deficit was $US 1.29 TRILLION
• White House projections for fiscal 2011 are for an official Treasury deficit of $US 1.5 TRILLION

In fiscal 2009 and early fiscal 2010, the Fed directly monetised an official $US 300 Billion of US Treasury debt. Between November 2010 and June 2011, the Fed plans to buy another $US 900 Billion worth. Nobody, including the Fed knows what will happen after that.

When looking at these figures, it is wise to remember that what is being “produced” here is the reserve currency of the world. This is why the US government has gotten away with this borrowing as long as they have. And it is also why the Fed has been able to accommodate them with non-existent official interest rates for as long as they have. But for how much longer?

That is the 64 quadrillion dollar question.

The federal budget deficit rose to $150.4 billion last month, the largest November gap on record. And the government’s deficits are set to climb higher if Congress passes a tax-cut plan that’s estimated to cost $855 billion over two years.

The Treasury Department says November’s budget gap was 25 percent more than the deficit in November 2009.

For the first two months of the current budget year, which began Oct. 1, the deficit totals $290.8 billion. That’s 2 percent less than for the same period a year ago. And economists had been estimating that the full-year deficit would decline after two years of record highs.

But analysts say the tax deal President Barack Obama reached with Republicans this week will give the 2011 budget year the largest deficit in history — $1.5 trillion, according to economists at JPMorgan Chase. It would mark the third straight year of trillion-dollar-plus deficits.

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According to the U.S. Treasury Department‘s Bureau of Public Debt, the U.S. national debt stood at $ 12,684,570,896,780.80 as of March 30. That’s not a typo… we’re talking about more than $12.684 trillion – or roughly $41,200 for every man, woman and child in this country.

By the time you read this, however, that number will be even larger: That’s because the level of public debt is growing at an average of about $4.02 billion per day – and has been since September 2007.

Americans have become so used to hearing about the national debt, and so used to the huge numbers associated with it, that they’ve essentially become immune to the whole topic and just accept it as a fact of life. In doing so, unfortunately, they miss a very important point: In order for the federal government to borrow this money, someone has to be willing to lend it.

This really hasn’t been an issue in years past because our government has financed the bulk of our national debt by regularly auctioning new Treasury securities of varying maturities ­- from as little as 90 days to as much as 30 years, generally speaking – to the public, which includes institutions such as banks and mutual-fund companies, private investors and, most notably, foreign governments and central banks.

As of the end of March, Treasury securities buyers held almost two-thirds of the total U.S. national debt, or roughly $8.2 trillion. That equates to about 56% of the U.S. economy’s annual output, as measured by gross domestic product (GDP). The remainder of the national debt – about $4.48 trillion – is money the government owes itself as part of reserve funds for various programs, such as Social Security.

Although the massive national debt is troublesome, as is the continued deficit spending, we could probably live with this situation, assuming the economy continues its recovery. After all, government debt has been a major feature of American life for decades, now.

Unfortunately, the federal government keeps creating new debt, and trying to sell more Treasury securities to finance it, meaning the demand for those securities is falling sharply.

And by all indications, this decline in demand could get worse.

In fact, if you look at recent Treasury sales numbers, it appears that international buyers – led by China and Japan – are drastically reducing their purchases of long-term U.S. bonds, notes and stocks.

According to recently released data, foreign purchases of U.S. Treasury securities declined to a net total (total purchases minus total sales) of just $19.1 billion in January, down 69.8% from $63.3 billion worth of net purchases in December.

China accounted for a huge chunk of that drop, selling $5.8 billion more in U.S. debt securities than it purchased, which reduced Beijing’s total holdings of U.S. government paper to just under $890 billion. This was the third straight month in which China was a net seller of U.S. debt, extending a downward trend that stretches back to July 2009, when China held almost $940 billion in U.S. Treasuries.

Japan, the second-largest foreign holder of U.S. debt, was also a net seller in January, with Tokyo’s holdings falling to $765.4 billion, a decline of $300 million from the month before.

It’s been more than a year since I first warned that this storm was brewing. Foreign governments were growing disenchanted with Washington’s inability to keep its financial house in order, particularly since that escalated concerns about the safety of the U.S. dollar. On top of that, overseas central banks are exceptionally concerned about the U.S. Fed’s insistence on maintaining artificially low interest rates – a more-recent development that’s nevertheless exacerbating fears about the health of the U.S. greenback.

Those fears are finally coming to a head. Now, barring some quick policy actions in Washington, our foreign creditors may well take matters into their own hands – possibly even staging a “buyers’ strike” against new U.S. Treasury offerings – ostensibly in an effort to force the Fed to raise U.S. interest rates.

In what would stand as a dramatic example of the classic supply/demand equation, the sharp drop in foreign demand for U.S. government debt in the face of the inevitable steady increase in supply could cause bond prices to plummet.

Couple that with the inverse relationship in the pricing of Treasury securities, and we would see bond yields zoom in order to attract sufficient buyers. Millions of investors would get crushed.

Historically, China has moved with practiced caution in this area. But as the fallout from the global financial crisis continues to play out, my sense is that as China’s domestic markets gain power (and exports become less important) Beijing could react both quickly and decisively if it feels threatened, or even just insulted, as was clearly demonstrated in the recent showdown with Google Inc. (Nasdaq: GOOG).

Unfortunately, at least where China is concerned, there seems to be something of an ill wind blowing in Washington, with gusts that at times appear both threatening and insulting.

For some time now, the United States has been trying to get China to let its currency, the yuan, appreciate against the dollar, a move that would help stem a growing upward trend in the U.S. current accounts deficit – in simple terms, the amount by which the wealth (in all forms) that’s flowing out of this country exceeds the wealth that’s coming in.

For the last two years, China, in order to support its own balance of trade, has resisted holding the yuan steady against the dollar. By devaluing the yuan, China makes its exports seem cheaper to foreign consumers, which generates larger trade surpluses and brings in more cash to bolster the $2.4 trillion in foreign reserves the country already holds. China accounts for 31% of the world’s foreign reserves, according to recent published reports.

As a result, Washington will decide later this month whether to declare China a ” currency manipulator” – a seldom-used designation that would allow the United States to impose a variety of trade restrictions, including new tariffs, import quotas and the like. In my opinion – shared by many others who closely follow China-U.S. relations – that would undoubtedly provoke a trade war, in which both sides would ultimately lose.

More potentially damaging, however, would be a decision in anger by China to retaliate by completely halting new purchases of U.S. Treasury securities – a move that would severely hamper Washington’s ability to borrow money to fund ongoing government operations and future deficits. This year alone, Washington will need to issue a record $1.6 trillion in new debt just to fund the shortfall between tax receipts and projected spending.

Indeed, it’s highly likely that the big cutback in China’s U.S. Treasury purchases we’ve seen during the past three months is meant as a warning of Beijing’s willingness to play hardball. It’s also a sign of China’s growing unhappiness with Washington’s spendthrift ways and the way in which the U.S. government has undermined the value of its own currency.

It’s a warning Washington would be ill advised to ignore.

The United States would be better served to allow interest rates to rise to realistic levels, while also shifting the domestic focus from artificial “stimulus” to reduction of the federal deficit. Such a strategy would undoubtedly cause significant near-term pain. But it would put the U.S. economy on course for sustained, healthy growth, while simultaneously bolstering the nation’s relationship with its foreign creditors.

If you see a similar scenario as inevitable, consider investments such as the ProFunds Rising Rates Opportunity Investment Fund (RRPIX), which is positioned to post substantial gains as interest rates rise.

You could also consider creating a hedging program of your own, using such exchange-traded-fund (ETF) investments as the SPDR Gold Trust (NYSE: GLD), or the United States Oil Fund LP (NYSE: USO). Those two ETFs closely track the world’s two most actively traded “currency alternatives” – gold and oil.

Many governments around the world see this same trend unfolding. Those nations have already started establishing non-currency “reserves” as a hedge against this contingency, and are making serious investments in gold, oil, minerals and other commodities. With the long-term economic growth projected for China, India and other emerging economies, commodity prices are destined to rise in price anyway, which makes those commodities a sound investment, as well as a viable hedge.

It’s a trend that U.S. investors would do well to note.

[Editor's Note: Money Morning Chief Investment Strategist Keith Fitz-Gerald is a perfect 22 for 22 with the recommendations made for his Geiger Index advisory service. It's a stunning record, but to those who know Fitz-Gerald well, it's actually not a surprise. A veteran trader, skilled analyst and noted market tactician, Fitz-Gerald is known for being able to see through the confusing haze of today's quickly changing markets to visualize and understand what the future really holds. This ability to predict looming changes is a key reason Fitz-Gerald is also able to divine the profit opportunities those changes will create. It's also a big reason he's been able to maintain a perfect track record with The Geiger Index. If you would like more information about the Geiger service, please click here.]

U.S. President Barack Obama’s Fiscal 2011 budget will generate nearly $10 trillion in cumulative budget deficits over the next 10 years. That’s $1.2 trillion more than the administration projected, and will be enough to boost federal debt to 90% of U.S. GDP by 2020, the CBO reported last week.

Back in early February, when the White House Office of Management and Budget (OMB) released its Fiscal 2011 budget, the Obama administration projected a 10-year deficit total of $8.53 trillion. The CBO studied that budget and the deficit figures, and concluded they were low – estimating that President Obama’s budget would generate a combined $9.75 trillion in deficits over the next decade.

Granted, the Obama administration came into office amid the worst financial crisis since the Great Depression. U.S. public debt was $6.3 trillion, or $56,000 per household, when President Obama took the oath of office. A little more than a year later, federal debt has reached $8.2 trillion ($72,000 per household). And if the CBO estimates are correct, the nation’s debt burden will reach $20.3 trillion (more than $170,000 per household) in 2020, reports The Washington Times.

At  $20.3 trillion, the nation’s debt would be equal to 90% of the projected U.S. GDP for 2020 – up from 40% of GDP at the end of 2008 and 53% right now.

America’s debt-to-GDP ratio hasn’t been near the 100% level since the end of World War II, when it peaked at 109%. If you want a point of comparison, Greece, the debt-default candidate du jour, saw its debt load hit 115% of GDP last year.

Does this even matter … or is it just a game of numbers?

If it doesn’t matter now, it will later on as the U.S. debt burden continues to increase. In fact, a new research study seems to indicate that the high debt load could crimp future U.S. economic growth. The recent research study – conducted by economists Kenneth S. Rogoff of Harvard and Carmen M. Reinhart of the University of Maryland – found that for countries with debt-to-GDP ratios “above 90%, median growth rates fall by 1%, and average growth falls considerably more.”

According to the National Bureau of Economic Research (NBER), public-debt levels that reach or exceed 90% of GDP become highly problematic: The rising debt levels have likely caused interest rates to rise, because worried investors demand greater returns on federal bonds, while the massive interest payments required to service all that debt divert money away from other important government programs and other federal functions.

Says Isabel Sawhill of the Brookings Institution: “The interest can get so burdensome that the country can’t afford to repair its highways or educate its children or provide other essential services. You become a much weaker nation.”

But I would bet that even many of the people who saw it coming are likely shocked at the speed and depth with which the economic deterioration has progressed. A few random statistics and graphs regarding the state of the U.S. economy:

*In the Miami metro area, 28.8% of mortgages are currently at least 90 days overdue (i.e. in default). This leads the nation right now.

*Home prices have dropped by 50 or 60% in some areas of Las Vegas IN 2009 ALONE!

*Our federal deficit/surplus in chart form from 1901-2010:

*And finally, a chart that makes me confident that holding Gold makes more sense as a cash equivalent than holding U.S. Dollars – the St. Louis Adjusted Monetary Base:

Gold is a time-proven wealth preserving asset in periods of economic depression. Government-sponsored cash is also a time-proven wealth preserving asset in such periods as long as your timing is right. In other words, as long as you get rid of the government cash and trade it for something else before the inevitable currency devaluation hits. Me, I’ll stick with Gold. It’s been a better play than the U.S. Dollar so far and I don’t see that changing any time soon.

Picked up some more Yamana Gold (ticker: AUY) bullish call options today on weakness. Looking to buy more Gold stocks and/or Gold stock ETFs this week if further weakness occurs.

by Martin D. Weiss, Ph.D. 02-01-10

The next contagion is beginning to spread around the globe.

It is unexpected on Wall Street, misunderstood in Washington — and very dangerous.

It could sabotage the plans of the U.S. Treasury, the Federal Reserve, and many of their counterparts overseas.

It is …

The Collapse of Sovereign
Government Bonds

This is certainly not the first financial contagion of recent memory:

Back in 1997, we witnessed a currency contagion —hatched in Thailand, spreading quickly to the rest of Southeast Asia … smacking Russia in the gut … and sinking a major player in the U.S. derivatives market.

Then, 10 years later, came the debt contagion —incubated in a subsector of America’s mortgage market … soon infecting nearly all credit instruments … striking Wall Street like a sledgehammer … and mortally wounding the global financial system.

Those contagions were bad enough. Now, however, the contagion is beginning at a much higher level, in the most important financial instruments on Earth — long-term bonds issued by sovereign governments.

The Saga Begins in Greece

Just 116 days ago, on October 8, Greece’s benchmark 10-year bond was selling for 112.295. Today, it has collapsed to 92.13.

And the drama of its yield surge is even more striking — from only 4.41 percent to 7.14 percent, a jump of more than 60 percent in less than four months.

Coincidentally, I was in Greece not long ago, visiting the origins of Western democracy.

If a local soothsayer had told me that the next global debt contagion would begin there, blocks away from the Pantheon, I would have been incredulous. Yet that is precisely what has just happened in recent weeks.

Already, this contagion is spreading to other countries …

Portugal’s 10-year government bond reached a peak on December 1, 2009, just 62 days ago. And now it has also started to plunge virtually nonstop, with its biggest declines registered late last week.

British government bonds (gilts) are equally vulnerable.

Sovereign bonds in Spain, Japan, and other major deficit nations are also starting to get hit.

Next Victim: U.S. Government Bonds

In the global competition for investor funds, U.S. Treasuries are typically viewed as the “least ugly.” So global investors have usually been willing to pay a relatively higher price for them, grudgingly accepting lower yields.

This helps explain why U.S. government bonds have not been among the first targets of the contagion. But that does not protect them from becoming one of the next targets.

Indeed …

• The U.S. government suffers from the same, or worse, underlying disease as Greece, Portugal, or any other victim of the contagion — massive, out-of-control federal deficits. America’s red ink was $1.4 trillion last year and ANOTHER $1.4 trillion this year.
• Washington has buried its head in the same mound of sand as Athens and Lisbon — grossly underestimating (a) the size of the deficit, (b) its potential impact on investor confidence, and (c) the speed by which its bond prices can fall.
• Like his counterparts in Athens and Lisbon, President Obama ignored advisors who warned of a deficit disaster and has only just begun to seriously consider deficit-reduction measures. And yet he continues to avoid steps that can make a significant difference.

Specifically …

The president supports a commission to study deficit reduction (rejected by the Senate last week) … but the commission’s recommendations would be nonbinding with no clear process in place for implementation.

The president has proposed a freeze on some domestic spending, but the freeze will impact only a small portion of the budget, would not kick in until next year, and would include a mix of spending cuts and spending increases. It would have zero impact on the 2010 deficit and little impact on future deficits.

The president has promised to give TARP funds back to taxpayers, but has also proposed applying unspent TARP money to community bank lending — another lost deficit-reduction opportunity.

The president supports “pay as you go” rules for Congress — requiring new spending to be balanced against spending cuts or revenue increases. But the devil is in the details. If the rules have no truly sharp teeth, they will be ineffective.

My view: If the deficit was just $200 billion or even $300 billion, I might support and even applaud these small steps.

But in the context of back-to-back $1.4 trillion deficits and in the face of a looming bond market collapse, they represent barely more than too-little-too-late tinkering.

The Consequence of
This Complacency
Is Catastrophe

Sadly, although most advisors on the Obama team are now more conscious of the rising political tide against Washington bailouts and deficits, they not yet see the approaching tsunami arriving from Greece.

Money and Markets’ Mike Larson explains the situation this way:

“Imagine what would happen if Uncle Sam’s borrowing costs shot up like they have in Greece — by 60 percent! Imagine what that would mean for the cost of car loans, mortgages, and other products whose rates track Treasury yields! And imagine the impact on an economy still struggling to recover from the Great Recession! This is the next big story that few people are talking about.”

He’s right and he has been warning about it tirelessly.

But, alas, unless the Obama administration and Congress can somehow ax the budget or find a new gusher of revenues — both extremely unlikely anytime soon — collapsing U.S. bond prices and sharply higher long-term interest rates are unavoidable.

Like we saw during the contagions of 1997-98 and 2007-09 …

• Confidence in vulnerable investments — this time, long-term U.S. government securities — will suddenly collapse. Then, it was certain geographical regions or market niches. Now it’s threatening the CORE of our national essence.
• Investors will yank their money out in great haste …
• The avalanche of selling will drive ALL bond prices — government, corporate, and municipal — into an uncontrollable swan dive. And …
• The contagion will spread to any country on the planet that has the same obvious vulnerability to the disease — massive federal deficits.

There is, however, one outstanding silver lining in this new crisis: Sinking government bond prices — bringing surging costs for government borrowing — are the single most powerful market mechanisms for persuading governments to end their print-and-spend madness.

Provided we don’t fall again for the false promises of politicians — and provided we are willing, as a nation, to make the needed sacrifices — there IS still hope for America.

That’s one reason I don’t recommend you abandon the safety of Treasury securities. Rather, all along, I’ve made it clear the real concern is not with ALL Treasury securities. It’s strictly with longer term Treasuries.

The other reason is that shorter term Treasury notes (under a couple of years in maturity) are far, far less vulnerable than the longer term variety.

And U.S. Treasury bills (always shorter than one year) suffer virtually no price declines, even in the midst of a bond market collapse.

So stick with them. Yes, I know. Their yield is miserably low. But they still provide the world’s best safety and liquidity.

Just make sure you avoid all longer term notes and bonds — whether government-issued or not. When the market price of bonds declines, so does your principal value. And because of that loss in principal, any extra interest they might pay you could be wiped out in a heartbeat.

Good luck and God bless!

Martin

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