Mr. Gross Is Right – And Wrong At The Same Time.

Bill Gross the 'Bond King' on CNBC

The United States government is bankrupt.

Not the country. Not the people. Not the private sector, at least not all of it. But the U.S. state is finished. Most of the individual states are probably bankrupt, too, but the federal government for sure is.

When the market and then the broader public wake up to this fact things will get very interesting. There will be loads of turmoil. But on a longer time scale everybody who loves liberty, prosperity and capitalism should rejoice at this development. Government is the problem, as Ronald Reagan correctly said. Sovereign default will do a better job at getting rid of it than he did. And yes, it is inevitable. The same is, by the way, happening in Europe.

I am amazed how the folks in Washington who got the nation into this mess can still elicit a serious response from commentators and analysts for the pathetic political theatre they are staging with regards to ‘deficit reduction’. $10 billion dollars saving here, or 50 or 70 billion there. What’s the difference?

Drivel.

In February 2011, the month that just ended and that only had 28 days, the US government spent $ 223 billion more than it took in. A staggering record monthly deficit. On this scale we are talking a $2.6 trillion deficit for the year, compared to the estimated $ 2 trillion last year (when looking at the unadjusted ‘operating cost’ of running the government – the biggest in human history – rather than the ‘unified budget deficit’ with all its accounting gimmicks).

Let’s face it: Things are out of control.

Now investors are responding. Bill Gross, America’s most prominent and influential bond investor, sold all his Treasury securities. That is a good move, I reckon. Bravo! The U.S. state is in a debt trap. The only choice is default or inflation. Both hurt the lenders, the bond-holders.

But wait a minute. On closer inspection, Mr. Gross doesn’t appear to expect either.

If he were concerned about inflation he would not hold that much cash (23 percent of his fund) and other fixed income securities. And if he thought the government would default, he would probably not hold mortgage-backed securities, which are now on government life-support via the socialized and trillion-dollar-loss-making zombies Fannie Mae and Freddie Mac (note: these are the cuddly names for the menacing state-backed and now state-owned agencies, The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation – the guys who brought you the housing bubble!)

Of course, Mr. Gross is a bond market investor. He has to stay within his designated ‘investment universe’ of fixed income securities and cash. By getting rid of toxic Treasurys and by shortening his duration (a measure of his portfolio’s sensitivity to changes in the level of market interest rates) he stands a good chance of beating his competitors and delivering a positive absolute return in paper dollars, even if these paper dollars buy less and less.

But whoever is not restricted to these types of instruments but can allocate wealth to wherever he or she sees value should, in my view, stay away from fixed income altogether.

Sovereign default is painful but it would be a much better outcome than currency destruction (hyperinflation). You would lose money on government bonds and on bonds that are backed ultimately by the government: banks and mortgage-backed securities. However, your cash would not get wiped out in a hyperinflation, and many corporate bonds could still generate a return. Mr. Gross’ portfolio would do alright, I guess.

However, this is not the most likely scenario. Substantially more likely is ongoing money printing from the central banks and escalating inflation culminating in paper money collapse. This has happened numerous times in history. Remember, no paper money system survived for long. In this scenario Mr. Gross’ portfolio is going to lose big time in absolute terms.

Here is where I think Mr. Gross is wrong. According to the reports in the media, he sold Treasury securities because he is concerned that rates will rise when the Fed stops with its debt monetization. Of course, in our world of Big Government and Orwellian Newspeak, this is called ‘quantitative easing’ and duly reported as such by the media. But, in essence it is what most governments do when they run out of cash and when taxing the public even more has become palpably counterproductive: they ask their central bank to print the money the government needs. Something has to give, and that’s the purchasing power of the paper currency.

If Mr. Gross is right that rates will rise when the Fed stops manipulating the market in Treasury securities, why should the Fed then stop? The declared goal of this policy is to lower rates to ‘stimulate the economy to grow faster’, in the words of Ben Bernanke. So when rates rise, the Fed has to buy even more bonds. Why would they stop supporting the Treasury market?

And the official line on debt monetization, er, ‘quantitative easing’, is only half the story. The Fed is propping up the prices of government bonds to lower the funding cost of the government. Without artificially low rates the debt would spin out of control at an even faster pace.

The U.S. government suffers from an incurable borrowing addiction. It cannot cope with higher funding cost or with a reduction in borrowing. In its desperation it has already turned to the central bank as its lender of last resort.

In my view, the U.S. is about to enter the Weimar-Republic stage of paper money collapse.

Stopping the printing press, terminating debt monetization and establishing higher interest rates in order to save the paper dollar from increasing inflation – this is a policy program that would pretty soon entail consequences such as bouncing social security cheques or closing state departments. As I said before, the last time the Fed tightened policy meaningfully the entire government debt was a tad more than $800 billion (1979). At the current rate, the U.S. government is adding that much debt to its debt-pile every four months!

Mr. Gross is right to sell Treasury securities but wrong to expect monetary policy to tighten and quantitative easing to end. The Fed cannot stop its money printing without pulling the rug from under a hopelessly indebted government and a still highly leveraged financial sector. By the summer, the Fed will find excuses to continue with this policy. The recovery will be slow or non-existent. A high oil price – partially the result of the Middle East unrest, partially the result of the Fed’s relentless dollar debasement – will have dampened growth further. Inflation will be higher and rising but the Fed will continue to support the government. High unemployment will be the excuse.

Further debt monetization will, however, not mean low Treasury yields. As more and more people realize that the endgame is hyperinflation, yields will continue to rise. And then, I am sorry to say, Mr. Gross, cash and mortgage-backed securities offer little protection.

You should not fear the end of ‘quantitative easing’ but it’s continuation. That is the real danger.