Strange Days and Crooked Logic

06/20/2011 10:52 am EST

Focus: MARKETS

Igor Greenwald

Chief Investment Strategist, MLP Profits

Many of the markets’ assumptions are defying common sense, just like the politicians in Washington, writes MoneyShow.com senior editor Igor Greenwald.

These are the strangest of days in financial markets. Let’s count the oddities:

1. US finances are a bigger mess than ever, but…
Bond buyers are willing to lend Uncle Sam money at record-low rates, on the perverse assumption that if the economy stalls permanently, like Japan’s, those low yields might become attractive.

Right now, they’re well below the inflation rate, meaning the bond market is paying Washington to overspend. But it’s also rooting for the overspending to end, even though the resulting slowdown would further undermine the government’s revenue collections and ultimately its ability to pay its obligations.

1a. While we're on the subject of US debt…
The securities of an overstretched superpower up to its chin in debt are valued much more highly than those of listed companies sitting on a mountain of accumulated profits. What’s more, negotiations on the US debt ceiling seem highly unlikely to put the federal house in order.

Vice President Joe Biden’s stated target of $4 trillion in cuts over the next decade pales next to the $7 trillion in cumulative deficits the Congressional Budget Office projects over the same span under its “baseline scenario”—and much, much more than that under the current tax and spending policies.

Meanwhile, the private sector has ready access to fast-growing emerging markets and their relatively cheap and increasingly productive workers.

Many blue chips now yield more in dividends than the rate on the ten-year Treasury bond, and their balance sheets are the picture of health. Yet the privately employed investment mangers display an eerie fondness for the federal IOUs, despite our unsustainable fiscal course.

2. Sure, let's call inflation the problem…
Two years after a near credit crash, the deepest recession and bear market in 70 years, at a time of persistently high unemployment and slumping housing prices, the biggest bugaboo of the investing class is inflation—a phenomenon that was last a real problem 30 years ago.

It’s also the only process that can make the huge excess of public and private US debt manageable over time without torpedoing growth—even someone at The Wall Street Journal has caught on.

Yet inflation remains reviled across the heavily indebted land, which seems to prefer selective deflation by the lottery of unemployment.

NEXT: 3. Before you buy that one-way ticket to China…

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3. Before you buy that one-way ticket to China…
One of the richest and most livable countries in the world is widely seen to be in a long-term decline, because its many excellent multinational companies have become reluctant to invest or hire at home.

Meanwhile, one of the poorest and least livable countries is believed to be ascendant based on its high rate of growth. But China’s economy remains mismanaged, its resource base is grossly inadequate, and its system of political repression incompatible with rising incomes and the requirements of the modern world.

The big gains in China’s real-estate market are reminiscent of the final years of the US boom that ended so ignominiously.

Because China holds US Treasury securities of $1.2 trillion among its $3 trillion in (mostly dollar-denominated) reserves, it’s also widely assumed to hold the whip hand in the trans-Pacific relationship. In fact, it’s entrusted most of its hard-won wealth to the goodwill of the Federal Reserve and Congress, and its frequent frets about that choice are signs of weakness.

Beijing cannot stop buying US debt without derailing its growth and endangering one-party rule at home, and if it ever did the value of its current holdings would plunge. Meanwhile, Washington might get by instead with freshly manufactured dollars.

4. They're cutting for the oddest reasons…
Reportedly, one of the over-arching goals of the current budget-cutting in DC is to preserve the dollar’s status as a reserve currency—which is to say, to preserve the mercantilist policies of foreign governments that have helped put the economy in the hole it’s in.

On the plus side, the foreign love of dollars has permitted the US government and consumers to borrow heavily at rock-bottom rates. On the other hand, there are still those heavy borrowings as well as the lost jobs and a dearth of domestic investment.

Perhaps we should confer reserve status on the yuan and see if that doesn’t work out better for most Americans.

5. And perhaps the strangest thing of all: the lack of political imagination in Washington…
For example, in the current budget talks, Democrats are resisting cuts to Medicare while Republicans have balked at higher taxes—ruling out the two principal avenues for addressing these looming shortfalls.

The US Treasury continues to expose itself to long-term interest-rate risk by issuing short-term notes, when it should be selling all the 30-, 50- and 100-year bonds the market will bear to lock in the current low rates for as long as possible.

The Federal Reserve continues to informally target a 2% inflation rate, when 4% seems more appropriate to the economy’s circumstances. And no politician seems to understand that genuine cost containment in health care must start with employer-purchased insurance plans, not in futile attempts to cut the reimbursement rates for Medicare and Medicaid.

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It can be scary to invest in anything at all when asset prices and prevailing orthodoxies don’t seem grounded in logic. But in the long run, common sense should prevail, or else the simple passage of time might cure us.

I’m looking forward to the next inflationary boom, and the spectacular demise of the 30-year bull market in bonds. I’m looking forward to a time when the abiding cynicism about US prospects is proven wrong.

They’re called strange days for a reason.

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