The U.S. Government’s Dilemma

On some of the lowest volume of the year, the S&P500 moved up 2.2% last week.  The lack of volume suggests that the prices moved up with very little conviction.  The VIX (or fear) index slid to the lowest levels of the year, which suggests that investors are becoming extremely complacent.

As usual lately, the economic data were mixed and certainly not supporting the strong V-shaped rebound in economic activity that many equity market and economic forecasters have called for.  To start, the final revision to Q3 GDP was much lower than expected–only 2.2%, or almost 40% lower than the 3.5% originally reported.  While existing home sales surged (but only because of the temporary home buyer tax credit), new home sales plummeted to nearly the lowest level of the year.  Personal income and spending, while growing slightly over the previous month, were both lower than projected.  Durable goods orders came in much lower than expected.  Initial jobless claims were better than expected, but the continuing claims (when extended and emergency claims are included) were near record highs.

The technicals, for the S&P, on the daily charts are very overbought.  The weekly charts are still completing a gradual topping formation, and the monthlies are still in a two-year bear market downtrend.

Now that the Fed’s quantitative easing program (electronic printing of dollars used to buy Treasury’s and Fannie and Freddie debt and MBS) will be winding down over the next three months, the government is staring at a massive financing problem:  Because the Fed created $1.5 trillion of dollars to buy government debt in 2009, the NET amount of government paper sold to investors was only $200 billion.   Essentially, the Fed financed most of the $1.75 in NET new borrowing by the U.S. government in 2009.

But what happens in 2010?

According to the research performed by ZeroHedge, the U.S. government will need to borrow over $2.2 trillion, beyond the expiration of existing debt that needs to be rolled over.  Since the Fed has $200 billion more left with its quantitative easing program, this means that more than $2 trillion will need to be sold to investors in 2010.

As the folks at ZeroHedge so aptly put it, “Good luck”.   Think about it–the amount of U.S. government debt that needs to be sold to households or corporations or foreigners will be TEN times larger than the amount sold in 2009!

So what’s going to happen?

Here are the possible scenarios, all of them grim:

1. The Fed introduces another quantitative easing program, which will almost ensure that foreign investors will punish the dollar and start heading for the exits to dump dollar denominated assets.  The additional dollars will also make inflation much more likely to explode, meaning that nominal prices of assets and economic activity could rise, but in REAL terms, both would most likely fall.

2. U.S. Treasury rates soar.  This will be the natural way to lure buyers to such a huge supply of debt.  But the higher rates would slam the “green shoots” in the economic recovery sending GDP back into recession territory and unemployment soaring above the already nosebleed levels.

3. Scare some of the newly created wealth in the stock and bond markets into safe the arms of the U.S. debt markets.  In essence this means that the government could “engineer a market collapse” to induce investors to buy government securities instead.

One of these three scenarios MUST occur.  There really is no other option. 

Now let’s sit back, grab some popcorn, and enjoy the show.  This is going be a good one.

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