CBO: U.S. Debt Crisis On The Horizon

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
August 10, 2010

IN THIS ISSUE:

1. The Economic Recovery is Faltering

2. CBO Warns of a Debt Crisis on the Horizon

3. Treasury Bond Yields Near Record Low – What Next?

4. Protecting Your Assets When Interest Rates Spike

5. Conclusions – Dangerous Times Ahead

Introduction

The non-partisan Congressional Budget Office (“CBO”) released a very troubling new report in the last week of July. The new report is entitled “Federal Debt and the Risk of a Fiscal Crisis” and warns that we will face financial calamity if we do not get our massive budget deficits under control.

The CBO report points out that the national debt, which was 36% of the gross domestic product three years ago, is now projected to be 62% of GDP at the end of fiscal year 2010 on September 30. And it continues to ratchet up every year thereafter, even in the CBO’s “baseline” (more conservative) projections.

The CBO specifically warns that our out-of-control deficits could lead to the ultimate debt crisis when buyers of Treasury securities lose faith in the government’s promise not to default on these most trusted financial instruments. No kidding!

I have been writing about the perils of increasing our national debt year after year since back in the 1980s when I criticized President Ronald Reagan for doing so, and every president since him. The concern was that in 20-30 years, the ultimate debt crisis would come. Guess what: it’s now been 20-30 years, and even the CBO now warns that the day of reckoning is on the horizon.

This week, I’ll summarize the latest CBO report. After reading about it, you need to think seriously about how you will protect your assets when the day comes where US Treasury securities are no longer trusted – think sharply higher interest rates! This will be a continuing theme in the weeks and months ahead.

But before we jump into the latest troubling CBO report, let’s take a quick look at the latest economic reports, most of which have not been favorable. It has been several weeks since I wrote about the economy specifically, so let’s get caught up.

The Economic Recovery is Faltering

While it didn’t come as a surprise to my clients and readers, the latest report on 2Q Gross Domestic Product was weaker than expected. The Commerce Department reported the 2Q GDP rose only 2.4% (annual rate). That was well below the pre-report estimates of 2.5% to 3.0%. In fact, some forecasters had predicted growth well above 3.0% in the 2Q.

The news was not all bad, however. The Commerce Dept. revised its estimate of 1Q GDP from 2.7% to 3.7%, which was considerably better than the consensus estimate. Still, the trend is not good: 4Q +5.0%, 1Q +3.7% and 2Q +2.4%. With most of the latest economic reports looking negative, growth in the last half of the year could do well to stay in positive territory.

The Index of Leading Economic Indicators (LEI) fell 0.2% in June (latest data available) and has been down in two of the last three months. However, the LEI is still well above its recession low in early 2009. It remains to be seen if this is merely a pullback in the LEI, or if it is rolling over to the downside ahead of a double-dip recession.

Consumer confidence remains in a free-fall. After plunging sharply in June, the Consumer Confidence Index fell from 54.3 to 50.4 in July. Here is the official statement that accompanied the release of the Conference Board’s confidence index on July 27:

“Consumer confidence faded further in July as consumers continue to grow increasingly more pessimistic about the short-term outlook. Concerns about business conditions and the labor market are casting a dark cloud over consumers that is not likely to lift until the job market improves. Given consumers’ heightened level of anxiety, along with their pessimistic income outlook and lackluster job growth, retailers are very likely to face a challenging back-to-school season.”

The Reuters/University of Michigan Consumer Sentiment Index also fell sharply again in July. The index fell from 76.0 in June to 67.8 in July. This report also cited the weak employment situation and continued weakness in home prices as the primary reasons for the fall in sentiment. They also warned that consumer spending could fall even more as a result.

Rasmussen reported yesterday: “Following the release of Friday’s government report on unemployment and job creation, consumer and investor confidence has fallen to the lowest level of 2010. Just 21% of Adults nationwide now believe the economy is getting better. That's down from 30% on Friday morning. The number who believe the economy is getting worse is now up to 54%.”

The Commerce Department reported last week that consumer spending remained low in June (latest data available). Personal spending was unchanged in June, reflecting a third straight month of lackluster consumer demand. Incomes were also flat, the weakest showing in nine months.

Not surprisingly, the US personal saving rate continues to rise. The government reported last week that the personal savings rate climbed to 6.4% of disposable income. That’s the highest rate since the early 1990s. Most Americans are clearly concerned about another recession, so they are saving more even if they are not making more. On a related note, consumer credit continues to be in free fall. It’s no wonder then that retail sales fell 0.5% in June.

On the manufacturing front, the ISM index fell to 55.5 in July, down from 56.2 in June. Durable goods orders fell 1% in July, when forecasters had expected a gain of 1%. The government reported last week that factory orders fell 1.2% in June (latest data available). On the positive side, industrial production rose a modest 0.1% in June.

Last Friday’s unemployment report for July was dismal, to say the least. While the official unemployment rate remained at 9.5%, the internals of the report were considerably weaker than had been expected. The economy lost another 131,000 jobs in July, and the June report was revised from 125,000 jobs lost to 221,000 according to the Labor Department report. The unemployment rate held steady mainly because 181,000 people stopped looking for work last month, and are no longer counted as unemployed.

On the housing front, the news was mixed. New homes sales beat expectations in June with 330,000 units sold according to the Census Bureau. Sales of existing homes fell, however, in June to 5.37 million units, down from 5.66 million units in May. And the number of buyers who signed contracts to purchase homes fell in June, down 19% from a year ago. Housing starts were also weaker than expected in June at 549,000 units.

Economists continue to adjust their forecasts downward for the second half of this year in light of the latest mostly disappointing economic reports. Congressional leaders in Washington are now talking about more stimulus (read: pork-barrel spending), and President Obama seems more than willing to go along – surprise, surprise.

CBO Warns of a Debt Crisis on the Horizon

On July 27, the non-partisan Congressional Budget Office issued a new report entitled “Federal Debt and the Risk of a Fiscal Crisis.” The report warns that we will face financial calamity if we do not get our massive budget deficits down in the years just ahead.

The CBO report points out that the national debt, which was 36% of the gross domestic product three years ago, is now projected to be 62% of GDP at the end of fiscal year 2010 on September 30. And it goes up every year thereafter, even in the CBO’s “baseline” (more conservative) projections.

Most Americans glaze-over when they hear numbers about the debt-to-GDP ratio. Perhaps the following chart from the CBO will put it in some better perspective. As long-time clients and readers know, I have been warning about this problem for over 25 years.

Federal Debt Held by the Public, 1790 to 2035

Tracing the history of the national debt back through our history, the CBO finds that the national debt did not exceed 50% of GDP, even when the country was fighting the Civil War, the First World War or any other war except World War II. As you can see in the chart, the national debt declined sharply after World War II as the nation began paying off its wartime debt when the conflict was over.

By contrast, our current national debt is still going up and may end up in “unfamiliar territory,” according to the CBO, reaching “unsustainable levels.” They spell out the following economic consequences -- and it is not a pretty picture:

“Although deficits during or shortly after a recession generally hasten economic recovery, persistent deficits and continually mounting debt would have several negative economic consequences for the United States. Some of those consequences would arise gradually: A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers; that ‘crowding out’ of investment would lead to lower output and incomes than would otherwise occur.

In addition, if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output. Rising interest costs might also force reductions in spending on important government programs. Moreover, rising debt would increasingly restrict the ability of policymakers to use fiscal policy to respond to unexpected challenges, such as economic downturns or international crises.

Beyond those gradual consequences, a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates. It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the situation and sufficient time to make policy choices that could avert a crisis. [Emphasis added.]

But as other countries’ experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply. The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the government’s long-term budget outlook, its near-term borrowing needs, and the health of the economy. When fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal policy in response. [Emphasis added.]

If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation. A sudden increase in interest rates would also reduce the market value of outstanding government bonds, inflicting losses on investors who hold them. [Emphasis added.]

That decline could precipitate a broader financial crisis by causing losses for mutual funds, pension funds, insurance companies, banks, and other holders of federal debt—losses that might be large enough to cause some financial institutions to fail. Foreign investors, who owned nearly half of U.S. debt held by the public in May 2010 (or about $4.0 trillion, $1.7 trillion of which was held by Japan and China alone), would also face substantial losses.” [Emphasis added.]

Folks, this is some VERY STRONG language by the number-crunchers at the CBO!

Earlier this year, I reprinted the CBO chart showing their projected deficits over the next decade. Let’s take another look. As you can see in this table, the CBO forecasts the deficit to fall below $1 trillion in 2012 but it never falls below $724 billion, and then goes back to almost $1 trillion by 2017.

Projected Deficit

To be clear, the darker bars in the chart above represent the CBO’s “baseline” deficit projections before Obama released his 10-year budget forecasts back in February. The lighter bars are the deficit projections after Obama’s forecasts were released. Take special notice of the magnitude of the deficit increase every year compared to what the CBO previously projected.

If we include the then-record fiscal 2009 budget deficit of $1.4 trillion, our national debt will soar by almost $13 trillion by 2020. Here are the CBO’s latest deficit estimates through 2020, including the actual FY 2009 deficit:

FY 2009	$1.4	trillion	FY 2015	$793	billion
FY 2010	$1.5	trillion	FY 2016	$894	billion
FY 2011	$1.3	trillion	FY 2017	$940	billion
FY 2012	$914	billion	FY 2018	$996	billion
FY 2013	$747	billion	FY 2019	$1.2	trillion
FY 2014	$724	billion	FY 2020	$1.3	trillion

TOTAL $12.7 Trillion

Worst of all, the projections illustrated above may well be too optimistic. Most obvious, the CBO assumes there will not be a recession between 2010 and 2020. Really? They estimate that the economy will grow by an average of 3% in 2010-2011, and then grow by an average of 4.9% a year in 2012-2020. No recessions and nearly 5% GDP growth for nine years in a row is almost certainly a pipe dream.

With the global debt crisis still worsening, I don’t know anyone who believes these rosy CBO projections will be nearly accurate. If they are too optimistic, and I believe they are, we could be adding much more than another $12.7 trillion to our national debt by 2020. Frankly, I don’t believe the markets will allow this to happen.

Treasury Bond Yields Near Record Low – What Next?

As you can see in the chart below, the yield on the 30-year Treasury bond is incredibly low, currently at around 4%. But as you can see, it has been below 4% recently and may be headed to yet new record lows just ahead. There are a variety of reasons for this historic drop in interest rates but suffice it to say, for now, it is largely due to the sluggish economic recovery and the growing deflationary forces in the global economy.

US Treasury 30-Year Bond

Many investors do not understand how we can be running trillion-dollar deficits and exploding the national debt, yet interest rates are at or near historical lows. I will write in more detail about this in the weeks just ahead. But the main thing to keep in mind is: 1) these historically low rates won’t last for long; and 2) when they do start back up, they will almost certainly rise dramatically.

Protecting Your Assets When Interest Rates Spike

Whether you have a large or small investment portfolio, you need to be thinking about how you can protect your nest-egg if US interest rates spike higher. Why? If interest rates spike higher, that will be bad news for bonds and stocks. Most of us have stocks and bonds in our portfolios, so such a scenario could be doubly devastating.

But there are ways to help protect your portfolio from a spike in interest rates. Last week, I featured Hg Capital which has a Treasury bond strategy that invests both long and short, with the potential to protect you regardless which way long-term interest rates move. Think of it as a “hedge” if bond rates begin to move higher, as they inevitably will at some point.

We hosted an hour-long Internet “webinar” with the principals of Hg Capital last Thursday. You can view and hear that very interesting presentation at the following link:

Click here for the Hg Capital webinar replay.

I highly recommend that you listen to at least the first half of this webinar, whether you consider investing with Hg Capital or not. You need to be thinking about how to protect your bond portfolio should interest rates spike higher. Again, this is a theme I will be focusing on in the weeks and months ahead.

You may also want to take another look at Wellesley Investment Advisors, another bond advisor that I recommend highly. Wellesley invests in high quality, investment grade convertible bonds that have “put” and “call” options that provide additional flexibility when it comes to exiting the positions.

Most investors do not know how to participate in convertible bonds, so Wellesley can be a great diversification tool. More importantly, Wellesley’s excellent 15-year performance record has not been correlated to the performance of Treasury bonds or stocks in the past. I have a large allocation of my own money in this program, and I highly recommend it.

To view our recent webinar with Wellesley’s founder Greg Miller, click on the link below:

Click here for the Wellesley Investment Advisors webinar replay.

** If you cannot download the webinars, click on the following links to our written Advisor Profiles on these two professional money managers:

Click here for the Hg Profile.

Click here for the Wellesley Profile.

For years, most investors have been indoctrinated by the financial community to believe in the “buy-and-hold” investment strategy, especially when it comes to their stock holdings. As long-term clients and readers know, I have advocated for alternative investment strategies that have the flexibility to move out of the market from time to time, especially during bear markets.

Despite my persistent arguments, most investors remain in buy-and-hold strategies. However, with two bear markets in stocks in just the last decade alone, more and more people are now looking seriously at the “active management” strategies I recommend. So in addition to Hg Capital and Wellesley Investment Advisors, now may be the time to reconsider the actively managed equity programs I recommend as well.

As always, past performance is not a guarantee of future results.

Conclusions – Dangerous Times Ahead

Folks, I don’t know how to put it any more succinctly: the government’s own Congressional Budget Office is warning that we will face a serious debt crisis if we don’t get control of our trillion-dollar budget deficits soon. Believe me, government bureaucrats don’t make these kinds of inflammatory warnings unless they are truly scared.

Yet President Obama’s 10-year budget forecasts would have us almost double the national debt between now and 2020. This will be very bearish for bonds and stocks, in my opinion. Your investment and/or retirement portfolio has probably been hammered already by two bear markets in stocks in the last decade. If the CBO is right about a full-fledged debt crisis – one that takes down both bonds and stocks – it could make the financial crisis of 2008-2009 look tame.

All of us that have money to protect need to start thinking now about how we are going to do that. Buy-and-hold strategies, whether in stocks or bonds, will likely get hammered even harder if the debt crisis the CBO warns about comes to pass.

Whether it’s the active management strategies I recommend, or some others that may be out there, you need to be thinking about and planning for what may lie ahead, if and when we get to the point that investors (US and foreign) no longer trust the US government to make good on its debt. That will be the Mother of all debt crises.

Sorry to be negative but it is what it is,

Gary D. Halbert

SPECIAL ARTICLES:

CBO warns of a sudden “fiscal crisis” (official summary of the report)
http://www.cbo.gov/doc.cfm?index=11659

National debt set to skyrocket
http://blog.heritage.org/2010/07/29/cbo-warns-of-the-risk-of-a-u-s-fiscal-crisis/