Brett Owens is a leading on income investing; the editor of the industry-leading Contrarian Outlook ...
02/20/2004 12:00 am EST
In a standing room only, no-holds-barred speech, Martin Weiss offers a dire outlook on the US economy, deficits, and interest rates. Here, the editor of Safe Money Report, offers a detailed study of the past, its implications for the future, and steps to take to protect one's investments.
"The government’s recent budget proposal has a $520 billion deficit. In percentage terms, this is close to being the largest deficit in history. And consider that this new budget does not account for the costs associated with the wars in Afghanistan and Iraq, nor does it account for so-called off-budget items such as borrowing from the Social Security Trust Fund. The Medicare overhaul bill signed last year will now cost $140 billion more than previously expected. Spending is running amok and pork barrel projects are out of control. If you add up all these items, the deficit could easily exceed $1 trillion this year. It is spiraling out of control and is on the verge of tearing apart the fabric of the American economy.
"Many economists don’t care; they look at deficits and interest rates and they don’t see a connection. They point to years in which the deficit was going up, but interest rates were going down. Wrong. And to prove that, we've produced a landmark chart to show the connection between the deficit and interest rates. This chart goes back to 1954. Let me walk you through this step by step. The solid blue line represents the deficit as a percentage of GDP, based on official government estimates. The higher the line, the higher this percentage. The black line represents interest rates. However, removed from those interest rates are the inflation factor. These are interest rates themselves, without the impact of inflation. We call that the real interest rate. In other words, the Treasury bond yield is roughly 5% and they are estimating inflation at 1.5%, so the real interest rates would be 3.5%.
"Now, let’s look through history and see what happened. For the first 20 years of this chart, the real Federal deficit as a percentage of GDP stayed under 3% and interest rates stayed around the same level. Then, in the early 1980s, the deficit surged, to almost 5.5% of GDP and at almost the same time, real interest rates also surged to their highest levels in the twentieth century. So you can see that the timing of the surge in real interest rates was very close to the timing of the surge in interest rates.
"Now, let’s look at what’s happened since. On the right side of the chart, the gray line had been coming down gradually, while the deficit had been coming down gradually. Now, in the most recent period, we see a little bit of a discrepancy. The deficit line went all the way down, below the 0% line, and showed a surplus. But real interest rates didn’t decline as much. Why? Because there is a real deficit that isn’t included in the official estimates. And that is the deficits of so-called offline items. So even though the deficit line appears to move into a surplus, in reality, it did not.
"Looking at the latest period, we see a surge in the blue line. Based on the White House’s own estimates, the deficit right now is at $521 billion. That’s 4.6% of GDP. That’s not quite the highest in percentage terms, but it is getting very, very close. And if you take into consideration all the extra spending now locked in by policy that has already been deciding, the actual deficit is going to be a lot larger than what is currently estimated. A more realistic estimate would put the deficit at 7.1% of GDP. So what does that mean for interest rates? Just look at the chart again; interest rates that correspond to that level are close to 8% in real Treasury bond yields, without considering the inflation factor. If inflation is at 2%, then we would have 10% Treasury bond yields.
"The conclusion is shocking: the yield on long-term Treasury bonds, which is now around 5%, could double, just based on the impetus from the surging budget deficit. That has far-reaching implications. As rates move higher, you will see a massive flight away from the stock market and into fixed income. If you are holding long-term bonds, a doubling in the yield on new bonds will imply that similar bonds could fall in price by as much as 50%. If you have any long-term bonds, now is the time to get out. Step #1 one is to sell your vulnerable assets. Step #2 is to move those assets to safety, including such areas as precious metals, oil, and natural resources. And third, if you have risk capital, put some of it to work in a way that you could make money from rising rates.
"How can you turn this into a profit opportunity?" One relatively conservative way is to use a specialized mutual fund that is designed to go up when bond prices go down, and to go down when bond prices rise. It’s a bet on interest rates. If you’re looking for a bull market, then the best one you can count on in terms of reliability is a bull market in interest rates. In that case, buy Rydex Juno Fund (RYJAX ). This fund is designed to go up in value with a rise in long-term interest rates. For every 10% decline in the Treasury bond price, this fund is designed to rise 10%. If we’re wrong, and interest rates go down, then you could lose money. In my view, interest rates have to go up. There is just no way of avoiding it. If you go to Rydex and buy this fund, there is a $25,000 minimum. However, if you purchase it through a broker you can buy in much smaller increments."
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