Monday, August 1, 2011

Updates for July 2011

A friend of mine posted a thought on the US debt situation and proposed the following (thought it may be good to share some of the reasoning behind). Not saying right or wrong, just an opinion as well as my view.


My friend proposed 2 likely scenarios on the FED debt ceiling issue and the ballooning debt
  1. with fed bal sheet expansion
    • fed expands its bal sheet and purchases further up the curve probably in the 5-10y space, while 
    • simultaneously targeting speculation by hiking short rates
  2. with stable fed bal sheet - the fed extends its portfolio duration by either
    • rolling over expiring paper (buying short term) into the belly of the curve, or (Buy ST, Sell MT)
    • buying in the belly funded by selling at the front end, or (Sell ST, buy MT)
    • buying in the long end funded by shorter duration reverse repos (Sell ST, buy LT)
And so my reply was:
  1. Expansion + hiking rates - Expansion likely but raising rates is not possible
    • Expansion is very possible at the risk of inflationary effect on prices
    • Contraction of capital or leaving it at status quo is not possible so I left out that possibility
    • Rates wise, GSOs are still very sensitive to rates and not yet out of the woods and buying MT to LT debt will also signal a hint to raise rates accordingly
  2. Changing the term structure (Without expansion) - Possible but wont solve any key issues
    • Buy ST, Sell MT
      • Raises overall financing costs and rates in the long run 
      • Puts off current pressure on financing needs
      • Possible but will people buy when rates are artificially compressed in the future? Economy and Institutions will demand higher rates from new MT to LT issues 
    • Sell ST, Buy MT
      • Sell ST to suck in money, use the money to buy MT
      • Possibly lowering or controlling the interest expenses as well as requisite rates
      • Look at this diagram for latest FED assets 
      • However, more volatility in liquidity supply on demand of expiry of the notes
      • Puts strain on the already large debt principal
    • Sell ST, Buy LT
      • Essentially the same as above, just extending the liquidity period

Some thoughts on the Issues
  1. US Stats
    • GDP of US$ 14.12 trillion
    • Assets of about US$ 2.4 trillion 
    • Total debt owed of over US$ 14 trillion (of which 2/3 is public debt) 
    • Other off balance sheet liabilities of over US$ 52.1 trillion (social aid and medicare) and US$ 4.4 trillion intergovernmental debt
      • That's a equity deficit of over US$ 58 billion
    • US annual spending
      • US$ 0.45 trillion of interest expense
      • US$ 0.70 trillion of defense spending
      • US$ 0.85 trillion of healthcare spending
    • See: http://www.federalbudget.com
      • Only interest on debt is falling, the rest heading north
      • Debt to GDP is near 1945s high of 120% 
  2. A bulk of FED assets lies in MBS assets and I believe they are trying to sell down those assets and buy back notes as they have done in the past months (which has the effect of signalling rate hikes)
    • However that is little in respect to the amount of debt load US has incurred
    • With the current debt load and unstable economic output from the US, monetary expansion seems likely based on the FED discussions with simultaneous cutting of expenses and deficits. 
  3. In essence, in layman terms
    • US issue debt = receives cash 
    • US buys back debt = exhausts cash 
    • US print money = creates cash 
    • The reason for the huge negative equity is due to US raising debt to get cash to spend/fund on unproductive assets/ activities which leads to impairment of assets so asset value vanishes which debt remains
    • So if US wishes to pare down debt, they have to either 
      1. Buy back debt = exhausts cash = more cash in system = inflation 
      2. Cut down debt = agreement to impair the debt principal without cash infusions (owe $10 debt becomes owe $5 debt)
        • Also can manifest itself via currency devaluation
      3. Debt to equity swap = change debt to owning US's assets (which is not a lot anyway)
    • 3 is not likely and for 2 results in sudden major global shifts in risk benchmarks and financial markets. As a result, 1 is still the most likely path to take and eventually 2 will come gradually
    • However I am thinking if US devalues its currency (which is very likely), ultimately US will suffer from high inflation and yet a risk of people not spending. 
      • Hard to pinpoint inflation/ deflation since there's hybrid scenarios such as Stagflation. 
      • Does that ring a bell to you?

2 comments:

Dennis The Menace said...

The united states is over its head in debt if china and all the countries and all investors the world over shun the dollar. Interest rates would rise and the federal reserve would be forced to buy bonds from the treasury to fund the government and pay interest on all of the governments bills notes and bonds. When the buyers for united states debt obligations disappears the whole system will come crashing down. This is the type of thing that peter shiff has been warning everyone about when the ability of the united states to pay its debts becomes clearly in doubt all the buyers for united states debt securities disappears overnight.

PENNY STOCK INVESTMENTS said...

Nice take

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