The Startling Decline in Corporate & Governmental Credit Quality –
What Does It Mean to the Average Investor?
By Al Martin
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(1-8-07) Are U.S. Treasury bonds really Triple-A rated? The junk bond market says No.
This subject has never received enough coverage in financial media. The startling decline in credit quality in both U.S. government and corporate credit issuers that has occurred under the Bush Cheney Regime is being ignored to the detriment of the markets.
The evidence for the decline in credit quality is clear. The problem is that people don’t interpret it the right way because the bullish shills you hear every day on CNBC and Bloomberg do not dare to put a truthful interpretation on what the junk bond market is saying.
Let’s look at the current situation. We find that current 10-year domestic junk bonds are trading at only 73 basis points over 10-year U.S. Treasuries. That’s an all-time low spread, mindful that the 20-year moving average of that spread is 474 basis points.
What is this record low spread between junk and U.S. Treasuries telling us? The bullish pundits would have you believe that it is simply because there is no fear of risk in the marketplace, which is borne out by numerous volatility indexes.
For instance, the CBOE VIX, volatility index, the 90-day moving average being at a 10-year low, indicates record levels of complacency in both domestic equity and bond markets. That is true, but it is another reason that we are bearish on domestic equities and bonds.
However, the spin that gets put on it – that it is simply this record low spread between junk and U.S. Treasuries – has to do exclusively with complacency in the marketplace and near record liquidity, because the Federal Reserve continues to pump out money, which is also a global phenomenon, by the way.
All central banks continue to print money hand over fist. Just witness last week, the ECB (European Central Bank) money supply was up 9.3% in the last month. The world’s economy is now being sustained by ever increasing debt levels which are propelling consumption, whilst industrial production, or manufacturing continue to shrink. In fact, they’re at 12-month lows.
What has happened is that “Bushonomics”, i.e., sustaining economic growth through the never ending expansion of an artificially created credit bubble, is now becoming global, wherein debt levels, both in the United States and globally, at the governmental, corporate and individual levels, continue to increase in order to sustain consumption.
Even though we are in a low-interest-rate environment, we see the consequences in record corporate and individual bankruptcy rates globally. This is another telltale sign of a so-called debt overhang in the global economy.
The way I think this should be interpreted, and the way you might hear it interpreted within the markets, which doesn’t bleed through to financial media, is that 10-year junk paper is trading at 73 basis points over 10-year Treasuries, when the 10-year median spread is 473 basis points. (This is using round numbers.)
The junk bonds are junk bonds. Their credit quality hasn’t changed. What’s changed for that fraction to occur? It can only mean one thing: Despite Triple-A ratings by Standard & Poor, Moody’s and Fitch’s of U.S. Treasury bonds, U.S. Treasury instruments, in fact, are not Triple A. That Triple A rating is a ghost rating, on paper only, which is maintained by the principal rating services who have all publicly admitted in the past that they are under continuous pressure by the Bush Cheney Regime to rate U.S. Treasury instruments Triple A, as U.S. Treasury instruments have always been rated.
But the marketplace knows best. Remember, the market knows all. The market is the great arbiter of all economic affairs on the planet. The marketplace is telling you that U.S. Treasuries are not, in fact, Triple A, that they do not meet the requirements of Triple A paper, that, in fact, they’re more like Triple B paper.
Why do we say that? Look at the spreads between 10-year corporate junk paper and 10-year Triple B corporate paper, or so-called “marginal investment-grade corporate paper.” You see it’s about the same -- 73 basis points.
This would imply that the marketplace feels that U.S. Treasuries, at this point in history, carry an actual credit rating of nothing more than Triple B, maybe Triple B+, but that, in fact, they are not the Triple-A “gilt-edged securities,” which is the notion which has always been foisted upon everyone. This is an illusion -- that U.S. Treasuries are absolutely sterling and gilt-edged, when, in fact, that is not the case.
To further illustrate this, one need only look at the General Accounting Office’s prognostications from David Walker, Comptroller General of the United States and chief of the General Accounting Office, when he has said publicly that the United States will begin to lose its ability to service its debt after 2009.
In a 3-year time frame, that would be approximately the same future risk structure that a bond rated Triple B would also potentially face.
Therefore what the market is saying is a reasonable hypothesis -- that U.S. Treasury paper is Triple A in name only, and that, in fact, the yields U.S. Treasury paper are trading at by no means reflect the underlying risk of owning the paper.
Secondly, why is the junk bond market still so strong, the strongest it has been, as a matter of fact, in this 6-year credit deterioration cycle?
Why are junk bond mutual funds oversubscribed every time a new one is offered?
Why are the hedge funds pushing so much into the sub-prime and junk market?
The reason why is not the reason one would think. It’s not necessarily because of the higher yields in the higher spreads. And this is the interesting point to make. Why have so few investment-quality bond funds been originated in this country in the last 6 years?
The reason is because Bushonomics has created a scarcity of investment-grade paper because so many municipal governments and corporate issuers of bonds have seen credit quality deterioration in the last six years of Bushonomics that it is creating a scarcity of investment-grade paper. Less of it can be issued because there are fewer governmental or corporate entities that can issue it. It isn’t because the yields are not as attractive as junk. It is because there are fewer potential issuers of investment grade paper, as credit quality continues to decline..
That’s the reason there’s a scarcity of investment-grade paper. Certainly a reason that sustains the U.S. Treasury bond market at this point in history is the scarcity of paper due to credit-quality deterioration of potential corporate issuers because there are so few Triple-A corporate issuers of paper anymore.
Lest we forget, under the Bush Cheney Regime, 236 of the S&P 500 corporations have seen their credit ratings downgraded. That is a record. Never has there been such credit quality deterioration in the top 500 corporations in the nation in a 6-year time frame.
The conclusion is that Bushonomics, which is now becoming increasingly globalized, is building a credit bubble which is going to burst, and which cannot be sustained. That portion of consumption which is being lost through ever diminishing industrial production and manufacturing cannot endlessly be made up for by expansion of debt-financed consumption. At some point, the credit bubble has to be popped – when all of that debt can no longer be serviced.
Now, the counter-argument to this has been, for the last 3 or 4 years, (you hear the bullish shills talk about this all the time) that the central banks – the U.S. Fed and all global central banks – can keep their foot on the money-printing accelerator endlessly because, as we have seen, global money supply growth under the Bush Cheney Regime has grown 73% in 6 years. It’s absolutely unprecedented. When you hear the term ‘the planet is awash in liquidity,’ that’s the reason why.
However, as this liquidity gets absorbed into debt that must be serviced without the concurrent increases in real wage income after inflation, without the concurrent increases in corporate profits, and without the concurrent decreases in governmental deficits, eventually you have a credit bubble.
People think of credit bubble and they instantly relate that to consumers. It doesn’t simply mean the people. It means all three legs of the stool. Every nation-state is a stool which sits on 3 legs – government, business and industry, and the people. The credit bubble infects all 3 legs of these stools, particularly with governmental debt levels being at record highs at the same time consumer debt levels globally are also at record highs.
The most pressing question, then, and the most difficult to answer: Despite this tremendous expansion in the money supply under the Bush Cheney Regime and the tremendous expansion in debt-driven consumption, why haven’t we seen the commensurate inflation that would normally go along with this economic phenomenon?
The reason why you haven’t is because there are still substantial deflationary pressures on the planet. Debt in itself, particularly governmental debt, is deflationary because the amount of spending that government generates from that debt does not make up for the cost of servicing that debt. Therefore, ever rising debt levels, in themselves, become deflationary, which exert downward pressure on the inflation that printing endless quantities of money are creating.
This creates a dangerous inflation/deflation cycle, which we are now seeing wrapped up into a global credit bubble. Will this bubble burst because of inflationary implications – i.e., central banks globally being forced to continuously raise rates to combat inflation? That’s unlikely. We have not seen that cycle even begin to happen yet because inflation has been contained.
What is different about this speculative bubble and why it so much mirrors the speculative bubble that burst at the end of 1929 is that the economic phenomenon, or what comes after the bursting of the current credit bubble globally, will be massive deflation, which, as any economist would tell you, is much more dangerous than inflation.
Why? Because economies cannot spend their way out of deflation the way that they can reduce interest rates or reduce money supply to break the back of an inflationary cycle. In a deflationary cycle, that doesn’t work. In a deflationary cycle, you are desperate to create inflation.
This, then, in our view, is the current situation of the economy on the planet, and it represents an enormous future danger of global proportions
So what about trading opportunities?
Global equity markets are fed by debt financed purchases of equities. Remember, margin levels now are also at record highs, as more and more securities are bought by more and more debt-financed consumption of equities thus leading to greater levels of overvaluation relative to available buying power. This in turn is creating a short sellers dream scenario.
If you buy 100 shares of IBM, it’s just like going to the grocery store and buying a loaf of bread. In a way, it’s still consumption. Consumption of stock, consumption of the bread. But if it is, in the last analysis, being debt-financed in some fashion, that becomes a problem because what happens is that prices of that which you are buying with debt must endlessly rise.
The play is the way we play it. And that is by shorting rallies, by being short-side traders.
Now, you can’t position-trade this because anyone who tried to put on short positions in equities last year and kept them would have gotten massacred. But what you’ve got to do is what we do. And that is, since we are day-traders, or short-term traders, we short rallies in equity, debt and commodity markets because that’s what you want to be doing in this environment.
If you don’t believe that a global speculative economic bubble exists, look at what commodity prices did in the past week…