The Government's Painkiller Won't Fix This Hangover

I'm writing to you from a cramped hotel room in Shanghai. Shanghai is 12 hours ahead of Wall Street, so all last week I stayed up all night watching CNN. I didn't want to miss any of the news.

What a mess.

I like to use the "hangover analogy" to describe finance... You get drunk. Then, you get a hangover. After that, you feel better. That's the way finance should work. You have a boom. Then, you have a recession. The recession paves the way for a new boom.

But starting in the early '80s, America adopted a new policy. It didn't want any more hangovers. It only wanted booms. So every time the hangover came along, it swallowed painkillers and downed more whiskey. Former Fed Chairman Alan Greenspan was the master of this. His favorite pill was the low interest rate. This resulted in consumption and debt. They get the economy moving again.

Thing is, every time you put off the headache, you're making the headache worse. And to keep putting it off, you need stronger pills and more alcohol. A perfect example of this was 2003. Greenspan moved interest rates all the way down to 1%. It was a desperate move, to stave off a desperately large headache... But it worked. By turning the housing market into a casino, he was able to put off the monster hangover.

Now, America has a headache again. This one is a searing, category-five migraine. The way I see it, the feds have a choice: They can do nothing and send the U.S. into the worst depression since 1930s... or they can swallow a packet of painkillers and a bottle of whiskey and hope the pain goes away for another few years.

We already know what route they'll choose. The government will soon start throwing every dollar it has at the financial system to make this headache go away.

First, the government will cut interest rates... possibly all the way to zero. This won't do much. The system has no more capacity to take on debt. So the government will step in and consume in the public's place. The U.S. government is already the world's largest debtor and spender. That's about to accelerate.

Politicians will design a new bailout package and start buying debts from the banks. Then, they'll start spending money. They'll take on new infrastructure projects. You'll see new highways and bridges in your neighborhood. You'll see new trains... maybe a new train station. Who knows, if the recession gets bad enough, maybe they'll start a new war.

Wars make recessions go away. They get everyone working again. And they funnel billions of dollars from the government into the economy.

Where will the government get the funds to pay for this consumption? It will raise taxes and issue Treasury bonds. What does it mean for us? Inflation.

The currency markets have already reacted to this inflation. The dollar has been falling for seven years against other major world currencies. Gold has also adjusted. It's up 250% since early 2001. Only one other inflation-sensitive market has yet to correct: the bond market. It's still near the top of a bull market that started in 1982.

Foreign central banks are the reason. They've absorbed $2.7 trillion of American government bonds in payment for the goods they've sent to America. Their willingness to hold these bonds has distorted the market and kept bond prices high. In effect, international governments – especially the Chinese, Japanese, and Middle Eastern oil exporters – are giving the U.S. government the green light to inflate as much as it wants.

The bond market is the most sensitive market to inflation. That's because inflation undermines the fixed-coupon payments bonds make to their owners. A $10 coupon might look fine today, but in 10 years, that same $10 won't buy a can of soda. When bond traders smell inflation, they cut bond prices.

The way I see it, this $2.7 trillion-bond position represents a huge overhang in the bond market. Add in another trillion that's about to flood the market to fight recession – and you've got the makings of a deluge.

Right now, the U.S. government has the highest possible credit rating. Its bonds are the definition of risk-free. I'm thinking we'll see deterioration in this credit rating... which would lead to rising long-term interest rates. This trade doesn't have the trend on its side yet... but it's one to keep an eye on.

Good investing,