Up the Creek Without a Paddle

This must be, without a doubt, one of the worst weeks we can remember.  Each day the news out of Japan goes from bad to more bad.  Here in the U.S. we gawk and grimace at the destruction wrought by the earthquake and tsunami.

Staples of developed countries, like power and fresh drinking water, have vanished as poor weather stifles relief efforts.  Immense human suffering, radioactive fallout, and worries that the next big one will hit any moment, leave survivors shell shocked.  A scenario any worse stretches the imagination.

At this moment economic consequences and money concerns seem shallow and trifling.  Yet that is our emphasis around here at the Economic Prism.  So we’ll go about our shallow business on your behalf…searching for hints and inklings as to what this means for money and markets – and more importantly, your money.

To get right to it, we offer one word of advice: Panic!

The stock market has been flying headlong into a crackup for months.  Last week, along the coast of northeastern Japan, it was delivered an all-time cataclysmic blow.  We find prospects for a quick rebound slim at best.

Here’s why…

Food Costs Sharpest Rise in 40-Years

Despite yesterday’s bounce stocks are headed down.  After peaking at 12,391 on February 18, the DOW has dropped over 600 points…with over half of the loss coming this last week.  Even without the Japanese disaster the stock market had gotten well ahead of the economy.

This week we learned that home construction plunged 22.5 percent in February.  This marks the biggest one-month drop since 1984.  But that’s not all.  Building permits fell 8.2 percent in February, to the lowest level on record, dashing even the most optimistic prospects for future construction.

If that weren’t enough, on Wednesday, the Labor Department reported that the producer price index, a measurement of wholesale price changes, rose 1.6 percent in February.  At that rate wholesale prices will increase over 19 percent annually.  Moreover, food costs experienced their sharpest rise in nearly 40 years.

“More expensive food means people have less money for the casual spending that helps the economy grow and create jobs,” reported AP.  “And it adds to growing concerns about inflation down the road, still a worry two years after the Great Recession.

“Many economists expect food prices to keep rising through the end of the year.  Consumer food prices will be about 5 percent higher this fall than the previous time last year, according to RBC Capital Markets.  That’s up from the current annual pace of about 2 percent.”

And that’s in addition to the fact that, “Food prices are already the highest since the U.N. began keeping track in 1990.”

Predictably, yesterday, food price increases showed up in the consumer price index, which logged a 0.5 percent increase in February – or 6 percent annualized.  What this mean is that, as you’ve likely noticed, rising food prices have come to a supermarket near you.  Weak economic growth mixed with rising consumer price inflation is not a bullish combination.

Nonetheless, the real effect to markets of Japan’s triple disaster will not be felt in stocks, but rather, U.S. Government debt…

Up the Creek Without a Paddle

Japan’s rebuilding efforts will increase their staggering debt – 200 percent of GDP last we checked.  At the moment, the Bank of Japan has already pumped over 60 trillion yen ($739 billion) of freshly printed paper money into its financial system since Monday.

More importantly to the United States, Japan happens to be the second largest foreign holder of U.S. Treasuries, owning $886 billion in U.S. Government debt.  Obviously, the Japanese Government will need to sell some of its holdings to pay for rebuilding and disaster relief.  When this happens, U.S. interest rates will rise…making borrowing more expensive.  For the U.S. Treasury this couldn’t come at a worse possible time.

Proving that Congress is not entirely comprised of dipsticks, what follows was posted on California Congressman, John Campbell’s website this past Monday…

“I learned something last week.  I learned that fully 40 percent of the over $9 trillion in Treasury debt currently outstanding to the public has a maturity of 3 years or less.  Put another way, it means that we are rapidly approaching $4 trillion in U.S. debt that matures by 2014 or sooner.  As I write this, the yield (interest rate paid) on a 2-year Treasury note is 0.645 percent or about 2/3 of one percent.  The yield, at the same time, on a 10 year Treasury note is 3.4 percent, and on a 30 year is 4.55 percent.

“By issuing mostly short-term notes, the Treasury is paying less interest, thereby keeping interest costs and, consequently, the deficit down.  In addition, the Federal Reserve is in the middle of its ‘quantitative easing #2’ (QE2) under which it is buying $600 billion of our own Treasury debt over about a 6 month period.  The Fed is not buying the short-term notes, but is buying 10 year maturities and longer in order to hold those rates down.  And, since the Fed is earning the interest thereon (paid by the U.S. Treasury), it is improving its yield.  We are currently running a deficit of about $130 billion per month, so the Fed is basically buying all of the new bond issuance from the deficit for almost 5 months.

“I understand that the Fed and the Treasury are trying to keep interest rates low and improve the economy and the deficit.  But, when coupled with the huge deficits, these moves look a bit like a Ponzi scheme that will soon unravel.

“We are selling the short-term bonds at cheaper rates to hold down costs now, but are leaving ourselves open to huge cost increases when interest rates go up.  And, we are at historic lows on these short-term bond rates.  If they were to rise by 3 points (which would put them where they were at as recently as 2008), our deficit would increase by another $150 billion per year, even if the long-term rates stay the same.”

In other words, we’re up the creek without a paddle.

Sincerely,

MN Gordon
for Economic Prism

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