Checkmate: How the federal government will lose in 2009

 Through a combination of incompetence and greed, the federal government has placed itself in a position of checkmate. There is no way to finance its budget deficits without devaluing the dollar or causing interest rates to rise.  With $10.6 trillion in debt, $8.5 trillion in new money created or given away in 2008, and multiple years of trillion dollar deficits planned by Obama, government has no way to fund its extravagances without either printing a lot more money or borrowing unprecedented sums.

This means that either Treasury bonds will crash, or the dollar will suffer significant devaluation relative to foreign exchange or precious metals, especially gold.

Market forces are telling the world to shed unproductive assets and shrink capacity, yet central banks and governments around the world, in particular the U.S., are refusing to listen. Rather than allow markets to snap back to sustainable equilibrium from previously artificial highs, the federal government clings to the notion that forcibly shuffling resources, propping up asset prices, and diluting the money supply will magically save the day.

There are consequences to everything. The consequences of shuffling resources (taxing productive ventures and doling out those resources to failing ones, i.e. bailouts) are stunted growth for good businesses and propagation of bad ones. Artificially propping up asset prices means that those who are generally less competent remain the custodians of society’s capital, and diluting the money supply inflates aways everyones wealth over time, particularly harming the poor and middle class.

For decades the federal government has gotten away with this reshuffle and inflate game, but the pawns are drowning, the rooks helpless, and the knights ready to turn on the King. Perhaps this is overly dramatic. Clearly, I doubt the capability of the Federal Reserve, Congress, and Obama to “fix” the economy; rather, I strongly believe they are destroying it by forcing us all to drink this Keynesian Kool-Aid. However, whether or not the economy recovers amidst this historic central government action, there are two phenomenon we can exploit to our advantage:

  • Short the US dollar
  • Short US Treasuries

In “When will the great Treasury unwinding begin?” I show how government debt has been bid to unsustainable levels and will likely fall. The one concern I see stated all too often is that the Federal Reserve will keep buying Treasuries to artificially depress interest rates. This will, it is claimed, keep bond prices inflated.  The one undeniable counter to this is that government must somehow fund its $1.2 trillion estimated 2009 deficit. It cannot do this buy issuing and then buying the same bonds. It can only raise revenue by selling bonds to other parties, or by diluting the money supply by cranking up the printing presses. There are no other options. There you have it-we have the government in checkmate!

The likely outcome is that they will try to do both. That is why I am heavily shorting both 30-Year Treasury bonds and the dollar. Both assets will likely lose as the government becomes increasingly desperate and the world’s biggest buyers realize there are better alternatives available. Make your bets now before it becomes treasonous to bet against Big Brother!

8 Responses to “Checkmate: How the federal government will lose in 2009”

  1. Cuervos Laugh says:

    I would start shorting the US Peso anytime now.

    Due to the ramp up at the end of yesterday with the approaching signing of the latest stimulus bill, it appears there’s going to be a rally.

    UDN/PSQ would be nice hedge against each other.

  2. If you like stats – I have another one for you.

    Most mathematical models are geared around the bell curve (thank you Herr Gauss) and the assumption is that all 99% of all data will fit within three standard deviations of the mean (average).

    The 3 Day Moving Average on the SPY in 2008 on both the loss as well as the bounce was in excess of 4 standard deviations (4 Sigma) of the mean.

    Then go back and look at the swings in valuation on the DOW in the first two quarters of 1929.

    Then I would suggest looking at Rogoff’s paper and doing some work with a copy of Excel and the Standard Deviation function on those stats and try looking at what the ranges would be at about 4 Sigma.

  3. Rob Viglione says:

    @Cuervos Laugh – Awesome stats, thank you. Averages are good, but of course predicated on historical data. Unfortunately, no two financial crises are identical. I’m trying to tone down my pessimism to think rationally and figure out how to best exploit current events, but I’m having a tough time picturing America turn its situation around with current policy.

    I think this country’s policies are becoming increasingly destructive towards business and capital. Rather than cleaning our economic house, we’re merely shuffling things around and pursing much more of the same policies that brought us to this disaster.

    Love the “American Peso” comment! I’m kicking myself for not going long USD merely as a hedge to the long gold and short Treasury positions I’d adopted last month. Hindsight is always 20-20…think I may lay off the short USD stance for a bit and wait until mid-year to load up again.

  4. Still not shorting the US Peso here.

    Since Jan 14, 09 – the USD has gained about 3% (tracked via UUP).

    Since Jan 2, 09 – it’s up about 5%.

    Oh, there is a negative correlation between the DOW and the UUP at about -0.86 strength.

    Not surprisingly, therefore – look at January’s numbers on DOW/S&P.

    Ken Rogoff has a working draft dated Dec 19, 2008 where he presents some fun facts about The Aftermath of Financial Crises:

    1. Average length == 6 years
    2. Average drop in housing value == 35.5%
    3. Unemployment increases on average for 4.8 years
    4. Average increase in unemployment is 7%
    5. Average real GDP drop timeframe average == 1.9 years
    6. Average real GDP drop == 9.3%
    7. Cumulative increase in public debt during banking crisis == 186.3%

  5. Rob Viglione says:

    @Cuervos Laugh – Excellent points about timing. Without significant changes in American policies, it is clear the USD will not be the reserve currency of the 21st century. As you stated, it’s just a matter of timing for when foreigners can divest themselves.

    There are two alternatives: catastrophic divestiture caused by some sort of credit rating shock, or gradual adoption of other currencies to substitute USD holdings. As a speculator, the first will make the most profit, but as a citizen I truly hope for the latter outcome.

    Although not likely, we can hope public policy changes sufficiently to bring America back into a globally competitive position.

  6. I wouldn’t short the US Dollar anytime soon if I were you.

    Look, the USD has already crashed. Check the history from 2003 to August 2008.

    There is a correlation between the USD and the DOW. When one goes up the other goes down. It’s one of the basic pillars of the US market and here’s the deal. Last week the UUP (US Dollar bullish ETF) just crossed the 50DMA.

    It bounced off the 200 DMA in December and has rebounded hard up the line.

    It will continue doing so until the vast majority of the USD holders outside of the US are able to divest themselves of the currency and THEN you and short the USD.

    It’s a toss up at this point what will be the reserve currency of the twenty first century: either the Euro or the Yen.

    Not the US Dollar.

    I wrote about this more in detail here for anyone with an open mind to the actual numeracy behind the market and not blind political analysis posing as market savvy.


  1. […] Checkmate: How the Federal Government Will Lose in 2009 I argued that our leaders were backing public finances into a predictable corner. With $2-3 […]