In Part I,
we covered the basics of wealth and political power in the U.S. and
found that the Fiscal Cliff is only a symptom of a structural endgame in
which the imbalance between what has been promised and what can be
collected in taxes will continue growing until it triggers a financially
driven political crisis that I believe will inevitably become a
full-blown Constitutional crisis.
Though there are many facets of this long-term political crisis that
are worthy of further exploration, we will to start with three financial
aspects that could start impacting households in 2013: a rise in
interest rates and a resultant destruction of bond valuations, a rise in
the U.S. dollar that negatively impacts U.S. corporate profits and thus
stock market valuations, and a reduction in upper-income households'
spending as a result of higher taxes that depress discretionary consumer
A Rising Dollar Negatively Impacts Stock Market Profits and Valuations
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Let's start with a topic that I have covered in depth over the past
year, the structural reasons behind the rise of the U.S. dollar (USD).
The recurring fantasy that Europe's fiscal and debt crises are "fixed"
and the Federal Reserve's money-printing/Treasury bond purchases have
recently depressed the USD, but in the longer term, the USD has been
tracing out an unmistakably bullish pattern of higher highs and higher
lows since May 2011:
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The key point here is the correlation between U.S. global corporate
profits and the USD: A weak dollar boosts corporate profits when stated
in dollars, and a strong dollar depresses corporate profits earned
overseas. This matters because many global corporations get 40% to 60%
of their total revenues overseas.
Thus any appreciation of the dollar versus the euro, yen, and other
floating trading currencies will lower corporate profits. Weakening
profits will then weaken the bullish argument for high stock valuations.
This currency-valuation dynamic is rarely mentioned in standard-issue
stock market analysis, even though it is obviously a key factor in U.S.
corporate profits and thus stock valuations.
Why would the dollar strengthen against other currencies? The
reality that Japan and Europe's fiscal and debt fundamentals are
deteriorating, not improving, is gaining traction. This alone is enough
to push the dollar higher. China's growth rate has slowed, and this is
impacting the Australian dollar and other commodity-based currencies.
Once again, the dollar will strengthen not so much on its merits as on
the weaknesses of its rivals.
Lastly, the contraction of global trade (just look at the Baltic Dry
Index for a reflection of this) will tend to push the dollar higher, as I
explained in my recent piece on Triffin's Paradox.
Interest Rates – Low Forever, or Set to Rise?
If there is any financial truism that is widely accepted, it is that
interest rates will remain low for years to come as a result of the
Fed's purchases of Treasury bonds and money managers avoiding risk
assets. These are definitely low-interest-rate positive, but received
wisdom may be overlooking two other forces.
The Fed has committed to buying about $500 billion of Treasury debt a
year, but perhaps this bond purchasing is not quite as dominant as many
seem to believe. The 2012 Federal deficit is around $1.3 trillion,
just like 2009-2011, and demographics and weak household income could
drive this higher in short order as the fantasy that tax revenues will
reduce the deficit run into the buzz saw of political/financial
dysfunction described in Part I.
In this context, the Fed purchases might cover about 35%-40% of debt
issuance. That could leave around $1 trillion in bonds dumped onto the
private market. The Fed's Operation Twist has suppressed interest rates
by selling longer-term bonds to buy 60% to 80% of short-term bond
issuance, leaving the Fed's program incapable of buying enough of both
long-duration and short-duration bonds to suppress long-term rates.
We must keep in mind that billions of dollars of bonds mature every
year and must be re-issued on top of newly issued bonds that fund
current fiscal deficits. This increase in the pool of issued bonds
further reduces the influence of Fed bond buying.
I have made the case elsewhere that the Fed may face increasing
political constraints as its policies fail to sustain growth in 2013.
Though some observers believe that the Fed has no choice but to expand
its balance sheet to infinity in order to keep buying Treasury bonds,
this view ignores the possibility of rising political resistance to Fed
manipulation of interest rates and the economy. At some point, policies
that have failed so visibly will no longer attract automatic political
In effect, the Fed's bond-buying programs have enabled fiscal
recklessness. As resistance to fiscal recklessness rises, so, too, will
resistance rise to the Fed's policies that enable the recklessness.
As the global recession causes phantom financial assets to vanish,
the pool of money available to buy Treasurys will shrink. Few seem to
ponder what happens when trillions of dollars in phantom assets
disappear as debt is written down and debt-based assets are exposed to
The Failure of Counterfeiting Risk-Free Assets
Stripped of public relations and economic voodoo-speak, the Fed's
policy of buying hundreds of billions of dollars in bonds is an attempt
to counterfeit risk-free assets – that is, to manufacture the belief
that Treasurys are risk-free. The notion that Treasury bonds may carry
risks that are not being priced into the current market price is
suppressed by Fed buying.
Are Treasurys truly risk-free? What matters isn't the debate; it's
the recognition that there could be risk as Federal debt spirals up by
$1 to $1.5 trillion a year. That recognition will eventually push
long-term rates higher as private buyers demand a risk premium. With
rates either near-zero or negative (depending on what rate of inflation
is used), any recognition of risk will eventually push yields higher.
If the Fed's programs run into political resistance, the recognition
of risk could rise quickly as the market discovers that the Fed is not
omnipotent and its bond buying has political limits.
What happens when yields on long-term bonds rise by a modest 10%?
The market value of all existing bonds of long duration will drop by an
immodest 10%, as yields and market value are on a see-saw.
What happens if bond yields rise and corporate profits decline?
Those holding stocks and bonds will suffer losses. This double-whammy
would leave few places for financial assets to hide in 2013.
Discretionary Spending and Recession
As taxes on the top 25% rise, those households will have less
discretionary income to spend or save. Since the top 10-15% earns
roughly half of all household income, the economy is dependent on the
consumer spending of the top earners. As their income is diverted to
taxes, consumer spending will suffer. If Federal spending is trimmed,
those receiving contracts, transfers, and benefits will also have less
income to spend or save. As spending declines, corporate revenues and
profits will also fall – another bearish influence on stock valuations.
All in all, higher taxes are recessionary for the consumer-based economy.