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Wednesday, December 10, 2008

Bailouts, Spending, Tax Day, and the Ten Year

Let's just asses how things look right now. We have already spent about $300 billion of about $750 billion for the banking bailout. We are about to spend $15 billion for an auto bailout, however the total bailout will run in the neighborhood of at least $100 billion once it is all done. On tope of this, President elect Obama is talking about adding a stimulus package that could run between $500 billion and a trillion Dollars.

U.S. stocks rose on Monday as investors bet that President-elect Barack Obama's plan for major infrastructure investment would help avert a deeper slump in the economy.

Shares of companies likely to be among the big beneficiaries of major construction projects, including Caterpillar Inc and chemical company DuPont, were standouts, along with shares of energy companies.

Investor sentiment also got a boost from signs that the Big Three automakers -- General Motors, Ford and Chrysler -- were closer to obtaining a government financial lifeline to avert possible bankruptcy. GM jumped 13 percent and Ford rose nearly 6 percent.

"With what Obama said at the weekend, that helped overseas markets and we're seeing follow-through here in the U.S. as well," said Alan Lancz, president of Alan B. Lancz & Associates Inc., an investment advisory firm in Toledo, Ohio. "News of a strong stimulus is the reason you're seeing stocks of hard assets like copper, cement up."

We are talking about an ADDITIONAL spending that could surpass $2 trillion. That is ADDITIONAL. So far, we have heard no mention of spending cuts anywhere else. As such, there still needs to be room for the government to function, for current entitlements to function, and for all other normal spending to continue.

This brings me to a potentially explosive situation. That situation is tax day 2009. Since the government has no intention of cutting back spending anywhere, that means they expect to pay for normal spending from tax revenues. Except, no one is making any money so there won't be any revenues. Since the end of September, the economy has gotten crushed. Businesses are losing money and going bankrupt. Corporations are all losing money. There has been no capital gains given the direction of the real estate and stock market. Furthermore, all we have done is lose jobs all year. As such, income taxes should be rather bare.

As such, I believe the government is in for a stunning blow come April 15th when they see just how little their revenues will be next year. What does this mean? At some point, the government is going to realize that they won't have enough money to fund their day to day operations. Now, a smart government would tighten its belt and function more efficiently. It might table some of the entitlement programs for instance. I don't believe that is what our government is going to do. Instead, it will borrow even more money to fund its day to day operations.

As such, it is very likely that we might see our deficit balloon by about $3 trillion in 2009. What does this mean for the 10 year U.S. Treasury bond? The Treasury bond is the Treasury's mechanism for borrowing. The further deficit will mean even more borrowing. Today, the U.S. Treasury is paying a rate of 2.7%. That means if the Treasury wants to borrow its debtors would get an interest rate of 2.7% over the life of the bond. This rate is nearly the lowest its ever been and it hit the lowest two weeks ago. I have already talked about the potential albatross of such low borrowing rates combined with so much borrowing.

Here is the rub, as Shakespeare might say. The government is about to ask the bond world for an obscene amount of new money and yet it wants this money at an obscenely low rate. Unfortunately, in any normal market those two things will NOT square. As such, the government is going to put massive amounts of upward pressure on the rate that U.S. Treasury bonds will pay. Yet, the market should already know about all of this borrowing and so one could surmise that it has factored it into the price of the bonds already. Yet, the infinitesimal revenues that the government is about to take in may not be factored in. What will happen when the government realizes that on top of the borrowing it has already done to pay for stimuli, it will need to borrow even more to pay to operate? It's likely that will be even more upward pressure on the Treasury bond, and all that means. It also means that my prognostication that one should be bearish on the Ten Year U.S. Treasury has been given even more evidence that it maybe correct.

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