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Hanging by a Single Horsehair
Significant problems lie ahead for our new President and Congress.

By Bill Fox, Senior Bonds Analyst
Tue, 11 Nov 2008 15:30:00 ET
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"Does not Dionysius seem to have made it sufficiently clear that there can be nothing happy for the person over whom some fear always looms?" – Cicero 
Fear and greed. The human predilection for cyclic, emotional progression and the basis of the Elliott Wave Principle. We are up to our necks in the fear side of the cycle, and for plenty of good reasons.
 
The U.S. Treasury is expected to borrow $550 billion in the next three months. So far, the demand for Treasurys has been good, but low yields indicate cash hoarding, and this does not bode well for the massive refunding needs of the U.S. government. Ironically, the only bright spot is a massive retrenchment of U.S. consumer spending: What is bad for a consumer-based economy is good for bonds, because we can finance our own debt (for a while) as the savings rate increases.
 
The latest poor GDP reading was only buoyed by an increase in government spending and exports. With money flying out of emerging markets, that export number will evaporate soon. Combine this with an already-projected $1 trillion budget deficit next year (not counting stimulus II, IMF funding needs, and the likely bailouts for auto and airline industries), we will look back at $550 billion in quarterly refunding as the good old days.


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In his Tusculan Disputations, Cicero uses the mythical Sword of Damocles as a moral narrative in his theme that virtue, not wealth and power, is necessary for fulfillment. Keep in mind that the Sword of Damocles was only hanging by a single horsehair.  

Speaking of hanging by a hair, commercial real estate has been downgraded to the intensive care unit. Consolidation, bankruptcies and forced-restructuring are just around the corner as hundreds of billions in debt rollovers comes due. Many large players are seeking to lessen the burden through assets sales, but nobody is buying even if you could find someone to lend.
 
And – have you seen the balance sheet of the Federal Reserve lately? If nothing else makes you fearful, that should. Don’t take my word for it – Richard Fisher, President of the Federal Reserve Bank of Dallas, projects that the Fed’s balance sheet will balloon to $3 trillion over the coming years with assets of admittedly dubious quality.
 
And let's not forget credit default swaps (CDS). These derivative contracts imply a multiplicative factor for cash outlays that is simply staggering. Unless something is going on with the Fed behind the scenes, I have not seen anybody publicly discussing this enormous Sword of Damocles. Just how much weight can that horsehair support?  

My point in all this is to suggest that significant problems lie ahead for our new President and Congress. Our near-term fiscal solutions and quality of leadership will have a lot to do with whether the Sword continues to hang – or falls.


Adapted from the essay published on November 6 in Bill Fox's Interest Rates Specialty Service. (See full menu for EWI's Specialty Services here.) 

Bill Fox is EWI's Senior Bonds Analyst. He has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his subscribers are professional bond traders spread around the globe.

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