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S&P Downgrade … Bubble Starting to Burst
Karibu (Welcome) G&G Readers,
The first-ever downgrade of U.S. debt, announced last Friday by Standard & Poor's, hit Asian & US stocks hard the last few days. That's what's going to grab the headlines, and that's what everyone's been talking about the last few days.
What most people don't realize, however, is that S&Ps downgrade could have an even more devastating impact in a far larger market — the debt market.
The debt market runs the world. It includes tens of trillions of dollars of government debts, corporate debts, and consumer debts.
With a stable debt market, the global economy grows; without a stable debt market, the global economy comes to a screeching halt and collapses.
And at the core of the global debt market are U.S. Treasury bonds. If Treasury bonds rise in value, so do nearly all other forms of debt. If they fall, they drag down the entire market. There is no other likely scenario.
The big problem: Treasury bonds are now a giant bubble; and by downgrading Treasury bonds, S&P has just punctured it …. Sssssssssss (simulation of air being let out of a ballon).
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What Created the Treasury Bond Bubble?
Answer: The same types of forces that created the tech bubble in the late 1990s and the housing bubble in the early 2000s: Wild growth!!!
Just in the five years after the Great Recession began, Treasuries outstanding will have grown by $5.6 trillion. Amazingly, that's $1 trillion more than the growth in all 232 years of America's existence before the Great Recession.
Artificial props: Treasury-bond prices have been artificially pumped up by a series of unprecedented government efforts — first, when the Federal Reserve pushed short-term interest rates down to nearly 1% in the early 2000s, driving up bond prices ... second, when it shoved rates down to zero in the mid-2000s ... and now, with its bond-buying rampages called "quantitative easing."
A sudden influx of new investors: Treasury-bond prices have been pumped up even further by investors who historically never invested heavily in U.S. government bonds — foreigners who were forced to buy the bonds simply because they had no other place to put all their unwanted dollars.
And unbelievably, according to the Treasury Department, foreign investors now hold $4.5 trillion in U.S. government securities, with the largest single chunk — $1.2 trillion — held by China.
False claims: And, sadly, Treasury bonds are a bubble because they've been supported by the “inflated” triple-A ratings of Wall Street's three credit rating agencies, creating a false impression of safety, “misleading” investors about the true risks, and leaving the entire market extremely vulnerable to downgrades.
Here's the key: By their very nature, bubbles are extremely fragile. All it takes is the removal of just ONE of its supports and the bubble is punctured.
And that's precisely what may have happened Friday afternoon when Standard & Poor's ended the era of triple-A for the government of the USA.
Bottom Line (BL): If you're still holding medium- and long-term Treasuries despite, take advantage of the flight-to-quality rally of the past couple of weeks and dump them now.
Or at least consider hedging your government bonds with an inverse exchange-traded fund designed to rise when Treasury-bond prices fall. Plus, in the days ahead, if you want to better gauge the global reaction to the S&P downgrade, the first market you should look at is not stocks, commodities, or the dollar. It's the Treasury-bond market.
With the U.S. economy sinking, with much of Europe collapsing, and with global investors rushing to buy Treasury bonds for safety, you'd normally expect their prices to surge.
If they don't surge — or if they actually decline — it will be your first signal that this giant bubble may have been punctured by the S&P downgrade, with far-reaching consequences.
Consequence #1
Disappearing Credit
Everyone seems to recognize that the S&P downgrade is a factor which will put upward pressure on borrowing costs for everyone. But it could be much worse than that — not just higher interest rates, but also a sudden exodus of lenders, making it impossible for most borrowers to get credit at almost any cost.
We saw this happen before in the mortgage meltdown, when most banks virtually shut down their home mortgage lending for everyone regardless of credit rating.
We saw it again in the wake of the Lehman Brothers failure, which I predicted to G&G Readers months before they collapsed. Thousands of investors, who typically make short-term loans to America's largest corporations, recoiled in horror. So the market for these short-term loans, called commercial paper, froze up and nearly died, threatening to instantly bankrupt hundreds of big banks and manufacturers.
We saw it happen again just last week as American investors, fearing a federal government default, suddenly withdrew $70 billion from money market funds. That was the biggest net outflow since 2008.
And we may see a similar pattern in the days ahead.
Recommendation: If you're planning to invest in a business, buy real estate, or just refinance, don't count on getting credit. Either be prepared to use cash or, better yet, seriously consider canceling your plans entirely. Depending on your situation, it may be a blessing in disguise; investing in this turbulent environment is too risky anyhow.
Consequence #2
Collapsing Municipal Bonds
If the federal government is downgraded, what happens to the bonds issued by local governments that get federal aid, guarantees, or supports?
S&P says it will consider up to 7,000 for downgrade. Result: A major rout in the municipal bond market.
Recommendation: Sell. Just bear in mind that the market for many municipal bonds can be slim and illiquid.
Consequence #3
Collapsing Corporate Bonds
If even Treasury bonds, always thought to be the gold standard of safety for the entire world, are no longer fool-proof, what about corporate bonds, which are almost invariably lower rated?
Given that U.S. corporations operate under the U.S. financial system, tax system, and legal system, is it even possible for an ordinary American corporation — no matter how big or strong — to actually be safer than the mighty U.S. government?
Some say "yes." Some say "no."
But the answer is immaterial. Because to cause a panic in the corporate bond market, all you need is a small minority voting "no" with their dollars and running for the hills.
Indeed, a sneak preview of that panic has already begun in the junk bond market: HYG, the exchange-traded fund that tracks junk bonds, has plunged from a high of nearly 92 on July 22 to a closing low under 87 this past Friday. That's its lowest level in over a year.
Recommendation: Also, dump corporate bonds. They may be less volatile than common stocks in the same company. But "losing less money" is not my idea of a positive goal.
Feeling stuck? Unwilling or unable to sell your bonds for some particular reason? Then seriously consider using inverse ETFs that go up when your corporate bonds fall.
Consequence #4
Bad News for U.S. Stocks
They're already falling due to the sliding economy and plunging consumer confidence. Add rising interest rates or credit market disruptions to the mix — and the market is suddenly under a red "crash warning."
So if anyone tells you there's going to be a flight to quality that drives investors from bonds into stocks, tell him or her to take a hike.
Common stocks are inherently riskier than corporate bonds and far riskier than Treasury bonds.
Yes, some may have believed Wall Street's assurances that "stocks are a safe bet for your retirement." But now most are asking: "If even Treasury bonds are not nearly as safe as we thought, how can anyone say common stocks are any better?"
Afraid of a crash? Looking for a way to get out or reduce your risk substantially?
It doesn't matter if the next big stock market crash begins this morning or not. Nor should you feel remorse for not acting sooner. They still apply right now!
Consequence #5
Falling Dominoes
The S&P downgrade could be just the first domino — merely a metaphor for the historic, life-changing, world-changing transformations that could vaporize massive amounts of wealth and create equally massive new fortunes. Ironic, isn't it?
BL: the underlying cause of the ensuing catastrophe is the great bond-market bubble that the U.S. Congress, the Treasury, the Federal Reserve, and the established rating agencies have created.
If you want to know how to implement a strategy to protect your portfolio and you are not already a GGIS Subscriber, what are you waiting on? Sign up today!
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Metta (Wishing You the Best)
Asar Gary Gray
Tax & Financial Consultant, RFC
G&G Associates
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LEGAL NOTICE: This work is based on SEC filings, current events, interviews, corporate press releases and what I've learned as a financial consultant. Nothing herein should be considered personalized investment advice. It may contain errors and you shouldn't make any investment decision based solely on what you read here. It's your money and your responsibility.
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