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What To Watch For This Week

 April 25, 2011 04:16 PM

In a stunning development last week, a Washington Post/ ABC News poll discovered that nearly 75% of Americans favor increasing taxes on the wealthy.  Now, since the focus of the Democrat's tax plan has been on raising taxes for the top 1% of American earners, I thought these numbers were a little on the low side.  After all, if your taxes won't get raised and it could help balance the budget, shouldn't the number have been closer to 99%.

This "insightful" poll also discovered that 42% of the public supports cutting defense spending, while 69% oppose cuts for Medicare.  Obviously, with the $14.3 trillion debt ceiling fast approaching, some action needs to be taken.  Even the notoriously behind the curve S&P rating agency chimed in last Monday by putting US debt on negative watch with a 1/3 chance that the agency will strip our nation of its AAA rating sometime in the next two years.

This slap in the face sent the markets down hard.  The S&P 500 tumbled nearly 2% during morning trading last Monday after the announcement, but recovered handsomely by the end of the week.  S&P cited a growing need for the U.S. to get its fiscal house in order.  The inability of Republicans and Democrats to work toward any sort of reasonable resolution was characterized as "political risk". 

But this isn't about a ratings agency that has been historically late to the game, or news organizations that conduct polls to determine the obvious, this is about a massive national debt and the irresponsible political posturing from our so-called leaders that could take this serious matter down to the wire.

Clearly, in the short run, the debt ceiling will have to be raised since no level of tax hikes or budget cutting will have sufficient impact in the current year to fund our existing obligations.  With expenditures in excess of $3 trillion for 2010, the quibbling over $30 or $40 billion in cuts would be comical if it wasn't so sad. 

In the chart below, you can see that 72% of U.S. spending in 2010 was allocated to four broad areas: national defense (23%), income security which includes federal retirement pay, unemployment compensation, and food and nutrition assistance (22%), Medicare (15%), and health (12%) which includes both services and research.

(Click on image to enlarge)

According to the Washington Post poll, Americans are not keen on cutting Medicare, but have indicated a willingness to take a swing at defense spending.  In 2000, prior to our entry into Afghanistan and Iraq, defense spending amounted to approximately $294 billion compared to more than $719 billion in 2010.  Total expenditures have more than doubled during that time, while the percentage allocated to defense rose just over 3%, so at first blush the increase may not seem out of line. 

Income and security jumped from $253 billion in 2000 to $685 billion in 2010, representing 18% and 22% of total spending respectively.  Much of the rapid increase in this category came during the last three years as unemployment benefits were repeatedly extended.  By default, in a growing economy that number should decline.  In fact, current estimates for 2011 in this category are for $595 billion -- down from $685 billion, representing a decline to 19% from 22%.  Defense, however, is expected to continue to grow in both dollar terms and as a percentage of the total, so that would seem to be a reasonable area to target.

In short, $90 billion from income security is expected to be saved just because the economy is set to improve.  You would think with that much savings by default, a few more cuts might actually get us on the right track.  Unfortunately, there is an estimated increase of about $40 billion for defense, $28 billion for health, and $40 billion for Medicare.  Oh and let's not forget a jump of roughly $63 billion in net interest payments, and that's with interest rates at unsustainably low levels.

Net interest payments are why getting the national debt under control and working toward government surplus rather than deficit is so critical.  With 2011 revenues expected at roughly $2.2 trillion, there's still some work to do just to approach balance, since expenditure estimates range from $3.1 - $3.5 trillion.

The real problem with the analysis is that the numbers are simply too large to accurately track or negotiate around effectively.  Additionally, the numbers vary from source to source.  We know that there's pork everywhere; millions of dollars spent for the benefit of few, and attached as riders to bills that require passage.  There's no doubt that the veritable status quo of senators and representatives squeezing as much as they can from the Federal teat will continue.

But this mess is not just the result of an inept Congress or executive branch -- the complicity of the Federal Reserve and Treasury Department have also helped to create this hole.  QE 2 will officially end in June, but the markets believe, rightfully so, that the maturing debt piled on the Fed balance sheet will be reinvested in more treasuries creating a de facto QE 3 lite.  In other words, to prevent indirect tightening of monetary policy, the Fed will likely maintain the size of its balance sheet.

Bernanke, who lives quite contentedly in a bubble, will continue to insist that flooding the markets with dollars is not inflationary until it shows up in wages and housing.  From that perspective, inflation will likely be a long way off, as the supply of labor remains well above levels that might be considered expansionary.  Housing is also likely to remain flat in the best case scenario for the remainder of the year.

Nevertheless, for those of us who do not live in a bubble, inflation is everywhere.  Whether it is consumers at the pump or the grocery store shelling out more and more with no wage increases in sight, or CEO after CEO telling us that input costs are rising and they will have to pass it along -- inflation is here and very real.  Until Bernanke gets this through his head, the dollar is likely to continue to weaken and commodities to continue to rise.

The short dollar/ long commodity trade is feeling very crowded, but that does not mean that the trend cannot continue.  However, there is likely to be increasing volatility on both sides of that trade and added risk as a result.  Stocks may also continue to appreciate as investors are forced to prefer risk assets of any kind to a no interest alternative.  The concern with stocks is that, if the economy stumbles, they may not provide the same rewards as commodities. 

Advanced GDP for the first quarter will be released on Thursday.  Current consensus is for a rise of 1.7%, well below the 3.1% rise during the fourth quarter of 2010.

This should prove to be a very busy week.  In addition to GDP, 180 S&P 500 companies will report earnings.  Expect to see a mixed bag, but keep an eye on management comments regarding input prices and expected increases in output prices. 

Also this week, Bernanke will face the nation on Wednesday after the conclusion of the FOMC meeting.  This is the first time a Fed president will host a news conference following a meeting.  The idea is that the Fed is entering a new era of transparency.  However, unless Bernanke shows signs of changing his tune when it comes to current monetary policy, the only thing likely to be clear is that he does not understand the impact of his actions.  The focus of the post meeting press conference will be questions regarding a post QE 2 world.  Guidance in this vein will not only tell us how long the madness will continue, but also when we might see the first interest rate hike.

I don't anticipate him revealing too much and until his views materially change, there will likely be money to be made shorting dollar rallies, possibly by going along the FXE, the Currency Shares Euro Trust, or another currency ETF of your choosing, and buying dips in silver and gold, which can also can be accomplished with ETFs in the form of SLV and GLD respectively. 

The concern here is that counter trend moves can be strong.  The dollar is heavily oversold, while silver and gold, both of which hit new nominal highs in Asian trading today, have held in overbought territory for some time.  The bottom line is that the trend of dollar weakness is likely to remain in place for some time, but it will pay to be very nimble; a whiff of a shrinking Fed balance sheet or small rate hikes could easily derail the trades.

In the long run America will survive and flourish, but the road will be rocky.


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