The recent announcement by the Bank of Japan that it will soon end its zero interest rate policy serves to illustrate the main reason why I am a longer term bear on the U.S. economy and dollar. The two principle factors that need to exist in order to cause hyperinflation have been set in motion and it is scheduled to arrive in the middle of the next decade. One is our massive debt and the other is the fiat currency system which will be employed to print the imbalances away. The reason why I believe hyperinflation is the more likely outcome, as opposed to a depression, is that hyperinflation is more palatable from the Government's standpoint. It only insidiously destroys the public's wealth, where as a severe economic downturn would be immediately pernicious for the consumer and not as easily disguised.
The end of the Yen carry trade, where investors could borrow yen at a nearly zero interest rates and invest that money in U.S. treasuries, demonstrates how vulnerable our bond market is to changes in foreign demand for dollars. Just that announcement sent yields rising across the curve and the 10 year treasury yield to 4.80% (a 20-month high). The surge in yields was just a preview of coming destructions. The damage will be done to our economy and our dollar in absolute terms and on currency exchange markets, which should send interest rates and inflation soaring.
The Bank of Japan has increased its holdings of U.S. treasuries 115% in the last 4 years alone. The dollar is also under pressure from China who has well promulgated its desire to distance the Yuan peg to the dollar, perhaps because it has increased U.S. treasury holdings 225% in the last 4 years. Our trade deficit now stands at a run rate of $822 billion for 2006. According to the Federal Reserve Flow of Funds Accounts of the U.S., as of 12/31/05 foreign holders owned 47% of U.S. treasuries. One has to wonder how much more of our country we are willing to sell away and how much longer foreigners will be willing to ignore their concentrated positions. But these are the good times. The challenges that this country faces in the next decade are staggering.
As we creep slowly toward 2017, when the social security trust fund needs to be tapped, the pressures on our dollar and economy will reach critical mass. In that year the government will no longer be able to rob from the trust fund, spending social security surpluses in the current year budget rather than setting them aside, and the flaws of our unified budget will be revealed. For example, noted economist John Williams has stated that according to GAAP, the actual budget deficit for 2005 alone would be 3.5 trillion, which would include the "off-budget" items e.g. hurricanes and wars as well as the segregation of funds collected for social security.
And the information above isn't just my own wild assertion. The following was derived from the Social Security Administration's Trustees' report: the federal government needs $5.7 trillion available to invest today in order to fulfill all of its obligations through 2079. Barring that, the total amount of negative cash flow through 2079 is $25.8 trillion! Even worse, according to the Medicare Trustees' report the shortfall in Medicare over the next 75 years is an additional $29.9 trillion. It is an inescapable conclusion to reach that the Federal Reserve almost has to resort to monetizing this debt. Americans do not have the savings in which to purchase this wave of new debt and we cannot count on the never-ending willingness of foreign savers to do so, especially since that appetite may already be starting to wane.
When one analyzes U.S. statistics of M3 money supply in conjunction with fed fund rates it is clear to see that either the fed is unwilling or unable to curtail monetary growth rates. It should also be noted that the Fed is not alone in the game of currency debasement. That is why I believe the dollar will drop against hard assets and certain currencies, but not all. It also seems clear that those who are not prepared to shelter themselves from inflation will be left far behind those who prepare now.
The Perennial Pom Pom Pundits, as I like to call them, claim that Foreigners will not abandon the dollar as their fortunes are inextricably tied to it. This is a specious argument. A good illustration would be to look at the some of the major inside holders of Enron stock. Did they balk at selling their shares when it became clear that the ship was going down just because it would hurt the share price? Even those who clung longest to hope sold what they could when the end became clear.
The central banks have historically shown their willingness to print money with alacrity in order to mask fiscal imbalances. Faced with the mounting debts in this country and the inability of our elected officials to face our greatest fiscal challenges I can only conclude the path of least resistance is the debasement of our currency. Investors: plan for continued, increasing inflation.
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