In the world of finance, circumstances can shift dramatically in a short time. Just a few weeks ago, stock market investors were experiencing a sense of optimism. On the first day of the month, the DOW closed at 13,279, marking its highest point since December 2007.
It seemed inevitable that the DOW would soon surpass its all-time high of 14,164 set on October 9, 2007. The anticipation was palpable. However, some investors were not on board; they were opting to sell instead.
“Sell in May and go away,” the wise old investors would say.
This advice has proven beneficial for those who took heed. Since May 1, the DOW has experienced a significant decline, falling 6.3 percent. Yet many analysts warn that the situation could deteriorate even further.
Economist Marc Faber has suggested that if the stock market continues to rise, we could be on the brink of a crash reminiscent of 1987. Similarly, author Chris Martenson foresees a looming crisis akin to 2008. Time will tell if these predictions hold true.
Meanwhile, the downward trend is not restricted to stocks. Commodities such as oil, gold, and copper, along with real estate prices, are also declining. But not everything is in freefall; U.S. government debt continues to rise.
A Great Election Year Stalemate
Yesterday, we were astonished to observe that the yield on the 10-Year Treasury Note had plummeted to just 1.70 percent. It’s important to note that as treasury yields drop, their prices increase. Who would choose to lend money to the government for a decade at such a low yield?
The answer is unsettling, as you’ll see shortly. First, some context is needed.
Investors seem to be flocking to treasuries for their perceived safety at a time when the U.S. government is nearing its credit limit. Treasury Secretary Tim Geithner warned that the U.S. is likely to hit its debt limit before year’s end.
Before Congress can raise this limit, Republican House Speaker John Boehner insists on spending cuts without any tax increases. In contrast, Democrats are advocating for tax increases without cuts to spending. This sets the stage for a significant political deadlock, which we are already witnessing.
“It’s simply not acceptable to hold the American and global economy hostage to one party’s political ideology,” stated White House Press Secretary Jay Carney on Wednesday.
Later that day, Republican presidential candidate Mitt Romney stood in front of a digital debt clock and proclaimed, “I find it incomprehensible that a president could enter office, criticize his predecessor’s record as irresponsible and unpatriotic, and then do almost nothing to rectify the situation while continually adding more spending.”
Clearly, the political drama will intensify as we approach the fall elections. However, at some juncture, the debt ceiling debate will shift from political discussion to market implications.
The Fate of Markets
Ultimately, when the stakes are high, Congress will likely negotiate a last-minute compromise to raise the debt ceiling—this has happened consistently in the past.
The fact that the U.S. government is financially strained is irrelevant. Similarly unimportant is whether global capital markets will continue to finance U.S. debt. In this digital age, the Federal Reserve is poised to intervene, providing funds to prevent the financial system from collapsing.
To illustrate, consider this: last year, the Federal Reserve acquired 61 percent of the government debt issued by the Treasury Department.
Yes, indeed. For verification, consult former Treasury official Lawrence Goodman. While it seems unbelievable, it becomes clearer when you recognize that the 10-Year Treasury Note yields only 1.70 percent. Yet, that’s just the beginning of the story.
Where does the Federal Reserve obtain the funds to lend to the government?
The answer may be more troubling than anticipated: the Fed simply makes an entry in its ledger and—voila!—creates money from thin air to cover the government’s vast budget shortfall. This cycle cannot persist indefinitely. Eventually, the dollar will face significant devaluation, or treasury yields will spiral out of control, at which point the debt ceiling will cease to be a matter for political negotiation.
As Ralph Waldo Emerson wisely noted, “Fate is nothing but the deeds committed in a prior state of existence.”
The actions of the past will undoubtedly shape our financial destiny.
Sincerely,
MN Gordon
for Economic Prism