US Outlook Deteriorates, Bond Yeilds Soar

The Federal Reserve is puzzled. So are we. The Fed is puzzled that Treasury bond yields are soaring. We are puzzled that the Fed is puzzled. Of course bond yields are soaring! Why wouldn’t they be?

If you happen to be the world’s largest debtor, and you happen to need another $2 trillion of credit from the rest of the world, you should not be surprised that your creditors demand a higher interest rate on the funds they provide. And yet, some members of the Federal Reserve are perplexed by this result.

“The Federal Reserve is not really sure what is driving the sharp rise in long-dated bond yields,” Reuters News reports. “Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain, meaning less need for safe haven government bonds and a healthy demand for credit?…Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar as the Fed floods the world with newly minted currency as part of its quantitative easing program?”

Um, yeah, let’s go with that second explanation.

Here in the “Twilight Zone” phase of the American response to the credit crisis, we find many otherwise-intelligent individuals – some of whom hold advanced degrees from Ivy League schools – advocating raw, unbridled debasement of the dollar. We also find legions of professional investors applauding the dollar’s debasement as a shrewd solution to the nation’s economic crisis. The advocates of dollar debasement are so numerous, powerful and vocal that they have conquered public opinion. (A massive stock market rally has not hurt the cause). Unfortunately, public opinion cannot conquer fundamental economic realities.

Only in mythology can a snake sustain itself by swallowing its own tail. Only in the logic of central banking can a nation sustain itself by purchasing its own bonds with a currency that the nation prints for itself. This process is utterly asinine, utterly ridiculous and utterly doomed to failure. The world simply does not work this way, no matter how many Harvard MBAs and Wall Street strategists argue the contrary.

“Current policies by the American government and the Fed are potentially wildly inflationary,” asserts Jean-Marie Eveillard, the legendary investor who recently retired as head of the First Eagle Overseas Fund. Nations do not generate or sustain wealth by printing currency. Neither do they generate or sustain wealth by amassing debts. Nations generate and sustain wealth by producing goods and services the rest of the world desires. Period.

Quantitative easing is Santa Claus for adults. Do you still believe in Santa? The Chinese certainly don’t. Every day the Chinese announce some new initiative to reduce or eliminate exposure to dollars – both now and forever more.

When the Federal Reserve announced its plan to purchase $300 billion in longer-term Treasury securities and $1.25 trillion of mortgage- backed securities (MBS) over a six-month timeframe, the Chinese must have said to themselves, “Surely the Fed is kidding!” But no, the Fed was not kidding. As promised, the Fed has already sopped up $700 billion worth of debt securities, paid for with newly minted dollar bills.

Is this really what high finance is all about? Maybe REALLY high finance…like the kind that would follow a Grateful Dead tour around the country for six months. But for those of us who believe in drug- free investing, the Fed’s quantitative easing policy is nothing but a fraud – a multi-trillion-dollar shell game. Simply stated, AAA credits do not repay their debts with currencies they print for themselves; they repay their debts from the proceeds of profitable capitalistic enterprises.

“An obvious culprit for the move in bond yields is the country’s record fiscal deficit,” Reuters remarks, “which will generate a massive amount of new government issuance. The U.S. Treasury must sell a record net $2 trillion in new debt in 2009 to fund a $1.8 trillion projected fiscal deficit, resulting from falling tax revenues, an economic stimulus package and sundry bank bailouts.”

Reuters, unfortunately, is an interantional news agency. So we’d guess that this story has leaked into the Chinese press. We’d also guess that the Chinese – along with every other major American creditor – will continue devising ways to move away from a dollar- centric economic model.

On the other hand, maybe your California editor is over-reacting. Maybe he just doesn’t “get it.” Echoing this sentiment, our colleague at the Australian Daily Reckoning, Dan Denning, observes, “Maybe we’re just being grumpy old bears about the whole thing. Maybe it’s time to admit that the bailouts, the asset purchases, the cash splashes, the quantitative easing, and the credit facilities all worked. They got us through the worst of it and good times are here again. Or at least less bad times (negative but improving good times).

“The only problem with that idea is that it’s not true,” Dan continues. “A huge amount of bad debt remains on bank balance sheets…And even if the market interventions were temporary (a big IF), the debt added by national governments to pay for the pain alleviation is not temporary. All that debt is a big fat drag on growth. And so it’s no surprise that when U.S. Treasury Secretary Tim Geithner goes to China and tells the Chinese that America will not inflate its way out of debt, laughter greets his remarks.

“Almost everyone outside America sees it the same way,” Dan winds up. “The debt amassed by households, corporations, and governments is real. It must be paid off, defaulted on, or inflated away. That’s why this balance-sheet recession – the liquidation of bad debts and the scaling back of debt itself – is far from over…”

The Daily Reckoning