Projections from the Congressional Budget Office show Washington racking up an additional $20.2 trillion in debt over the next decade. That would put the national debt somewhere around $54 trillion.
The national debt, which is the accumulation of annual budget deficits, is growing at a rate of roughly $2 trillion per year. Much of this debt is needed to make good on mandatory outlays like social security, medicare, and health spending. Some of the debt covers discretionary spending such as defense and transportation.
There’s also net interest on debt. This recently topped $1 trillion a year for the first time ever. Washington is essentially borrowing money to pay the interest on the debt. This is no way to run a country.
These projections – the $2 trillion per year deficits – generally assume everything remains status quo. That real gross domestic product increases at an annual rate of 2.4 percent. And that there are no new wars, pandemics, or other freedom inhibiting crisis events – whether intentional or not – that would blow these budget projections out of the water.
We all saw what an absolute cluster-potamus the coronavirus fiasco made of government finances. And how rampant money printing made wage earners and savers poorer as the cost of living went up.
The point is the CBOs projections don’t account for any number of calamities that are likely to occur at some point over the next decade. Similarly, investors and money managers may be underestimating the potential for the Israel-Hamas war spilling over into a greater regional or global conflict.
Certainly, the fulfillment of this prospect would have severe consequences for human death and destruction. It would also accelerate the U.S. governments debt spiral and wreak havoc on financial markets.
By this, we posit that during the initial fog of a geopolitical crisis, financial markets don’t have the faintest inkling of potential risk.
Charlie Don’t Surf
Perhaps the latest row in Gaza will be another slow-moving conflict that enriches defense contractors and adds to the U.S. government’s massive debt pile. That’s the experience over the last several decades – demonstrated by wars in Iraq, Afghanistan, and even Ukraine.
But what if there’s more to this story? Will the risk of a stock or bond market selloff be quickly overshadowed by the prospect of something much greater? Could the hellish self-annihilation of civilization be just moments away?
Author Frederick J. Sheehan Jr. wrote a piece titled, “War of the Nerds,” for the December 2006 edition of Marc Faber’s Gloom, Boom & Doom Report. Several years ago, the article was still posted at Sheehan’s now defunct AuContrarian website. By chance, before the site vanished, we preserved the following excerpt:
“Every generation suffers its particular fantasies. So it was a century ago. Investors had grown so immune to the consequences of war that bond markets from London to Vienna didn’t flinch after the assassination that provoked World War I.
“Three weeks later, in the summer of 1914, the fear premium amounted to a total of one basis point. Then, in quick order, European markets ceased to function. A notable feature of this paralysis is that nothing of substance had changed – war had not been declared by any of the parties, but by now, minds were hyperventilating.”
Indeed, like Charlie don’t surf, the complacency toward risk can quickly change. The detachment among many investors from a remote catastrophe can turn on a dime. As Sheehan observed, even without shots being fired, financial markets went from full functioning to completely immobile.
What Fear Premium?
Financial risk, for our purposes today, is not a quantified statistical measurement. We’re not concerned with the risk differential between short-term bonds and long-term bonds. Rather, at the opening of a major conflict, risk is specific to the probability of an aftermath that significantly destroys capital.
The question, in this regard, is how financial markets behave when a burgeoning geopolitical crisis hits. Obviously, there are plenty of other macroeconomic factors involved. But taking what can be observed for what it is, bond markets have been quick to dismiss a potential aftermath of significant capital destruction.
The day of the Hamas sneak attack was Saturday October 7. Using market close on October 6 as our starting point, the yield on the 10-Year Treasury has declined from 4.78 to 4.63. The fear premium – as bond prices move inverse to yield – has been less than zero. Similarly, the price of a barrel of West Texas Intermediate crude has fallen from $82.79 to $75.59.
The stock market, as measured by the S&P 500, sold off in late October and has since recovered. The S&P 500 is now about the same as it was on October 6.
Defense sector stocks like Lockheed Martin have been the real winners. Since October 6, LMT is up 41 points – or over 10 percent. Up until October 6, LMT was down 17 percent for the year. The latest boost has brought its year-to-date return to minus 7 percent.
Gold, while exhibiting more caution than Treasuries, is up roughly 7 percent since October 6. Most of the increase occurred between October 9 and October 27, with gold topping $2,000 per ounce. Since then, it has given back about $50 per ounce.
In short, with a possible exception for gold, the fear premium across various markets just over one month from onset of what could be a major war is generally nowhere to be found. What to make of it?
The War and Peace of Secular Market Cycles
Geopolitical shocks, as we understand them, generally increase the demand for gold. A threat to stability quite naturally challenges the durability of fiat money. Those who see through the thin veneer of full faith and credit desire to hold more gold and less fiat.
Presently, gold, as opposed to Treasuries and crude oil, is still maintaining some of the fear premium it added over the last 30 days. Of course, there’s plenty that can go wrong out there these days – all is not well.
Conflict escalation and spillover in the Middle East financed via the printing press is certainly a great big giant risk. This would further the long-term accumulation of gross financial imbalances that have occurred over the last 50 years.
Many people don’t understand this or won’t acknowledge it. The impending financial collapse is too uncomfortable to even consider. There’s a general unwillingness to recognize the financial maelstrom that has been building for several generations.
The specifics as to how it all goes down and when are uncertain. The reality of this prospect, however, should not be discounted.
The influence behind secular cycles remains the same: human nature. Secular bull cycles start with hesitation. There’s initially a skepticism that holds over from the prior bear market.
Yet, once the trend is firmly established the disposition in people’s minds shifts to the belief that the existing uptrend will remain permanent. Likewise, when the credit cycle turns, and interest rates climb, there’s a tendency to believe this is temporary.
As can happen, the ongoing rise in interest rates had gotten a little ahead of itself as of late. The pullback over the last three weeks is something that should be expected. This has happened numerous times over the last three years. Consider this a market head fake.
Yesterday’s upward spike in interest rates serves as a friendly reminder that the trend for interest rates is still up.
More war. More funny money. More inflation.
…this interest rate cycle still has several decades to go.
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Sincerely,
MN Gordon
for Economic Prism
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