This week has undoubtedly been one of the most challenging in recent memory. Each day, the news emerging from Japan continues to worsen, leaving us in the U.S. astonished by the devastation caused by the earthquake and tsunami.
Essential services like electricity and clean drinking water have disappeared, hampered by unfavorable weather that complicates relief efforts. The sheer magnitude of human suffering, alongside concerns about radioactive fallout and the possibility of further disasters, has left survivors feeling overwhelmed. Imagining a worse scenario is truly difficult.
While it might seem trivial to focus on economic implications during such a crisis, that is the realm we delve into at the Economic Prism. Thus, we shall continue our inquiries, searching for insights regarding the repercussions for financial markets—and more importantly, your financial well-being.
So, let’s get straight to the point: Panic!
The stock market has been on a tumultuous trajectory, and last week, it suffered a historic blow along the northeastern coast of Japan. The likelihood of a quick recovery seems slim at best.
Here’s why…
Food Costs Experience Sharpest Increase in 40 Years
Despite a slight uptick recently, stock prices are likely to continue their decline. After reaching a peak of 12,391 on February 18, the DOW dropped over 600 points, with more than half of that loss occurring last week. Even prior to the devastation in Japan, the stock market had outpaced economic reality.
This week revealed a staggering 22.5 percent drop in home construction for February, marking the largest monthly decline since 1984. Additionally, building permits decreased by 8.2 percent in February, reaching a historic low that dashed even the most optimistic forecasts for future construction activity.
As if that wasn’t enough, the Labor Department announced that the producer price index—a gauge of wholesale price fluctuations—rose by 1.6 percent in February. If this trend continues, wholesale prices could increase by over 19 percent annually. Food prices have seen their steepest rise in nearly four decades.
As reported by the Associated Press, “Rising food costs mean less disposable income for consumer spending, which is vital for economic growth and job creation.” Furthermore, this adds to persistent inflation concerns, lingering even two years post-Great Recession.
Many economists predict ongoing increases in food prices through the end of the year. According to RBC Capital Markets, consumer food prices could be around 5 percent higher this autumn compared to last year, a significant jump from the recent annual rate of about 2 percent.
Moreover, food prices are currently at their highest since the U.N. began tracking them in 1990.
Predictably, this rise in food prices has been mirrored in the consumer price index, which reported a 0.5 percent increase in February—translating to a 6 percent annual rate. As you may have noticed, escalating food prices have already impacted local supermarkets. The combination of sluggish economic growth and rising inflation is certainly not encouraging.
However, the true impact of Japan’s triple disaster is likely to be felt not in the stock market but in U.S. Government debt.
Up the Creek Without a Paddle
Japan’s rebuilding efforts will further inflate its already staggering debt, which stands at 200 percent of GDP. Recently, the Bank of Japan has injected over 60 trillion yen (approximately $739 billion) of freshly printed currency into its financial system.
Of particular concern to the U.S. is the fact that Japan is the second-largest foreign holder of U.S. Treasuries, owning $886 billion in U.S. Government debt. To finance recovery and relief operations, the Japanese Government will likely need to liquidate some of these holdings. This action would result in higher U.S. interest rates, increasing borrowing costs at an already inopportune time for the U.S. Treasury.
In a rare moment of clarity, California Congressman John Campbell shared important insights on his website last Monday:
“I learned that 40 percent of the over $9 trillion in Treasury debt currently outstanding to the public has a maturity of three years or less. This indicates that by 2014 or sooner, we may face nearly $4 trillion in U.S. debt maturing. As of now, the yield on a 2-year Treasury note is 0.645 percent, compared to 3.4 percent for a 10-year Treasury and 4.55 percent for a 30-year note.
“By favoring short-term notes, the Treasury has reduced interest payments, thus controlling costs and the deficit. Additionally, the Federal Reserve is executing ‘quantitative easing #2’ (QE2), which entails purchasing $600 billion of Treasury debt over a six-month period, primarily focusing on long-term maturities to suppress interest rates. Given our monthly deficit of about $130 billion, the Fed has effectively been financing our new bond issuances for nearly five months.
“While I appreciate that the Fed and the Treasury aim to keep interest rates low to stimulate the economy and manage the deficit, these strategies resemble a precarious Ponzi scheme that may soon unravel.
“We are selling short-term bonds at low rates now to minimize costs, but this strategy exposes us to significant increases when interest rates eventually rise. If short-term rates were to climb by three points, bringing them back to 2008 levels, our deficit could increase by another $150 billion annually, even if long-term rates remain stable.”
In essence, we find ourselves in quite a predicament.
Sincerely,
MN Gordon
for Economic Prism