Deficit, Fed, Post-Midterms

“In 2016, President Trump pledged to eliminate the national debt ‘over a period of eight years’ (“In a revealing interview, Trump predicts a ‘massive recession’ but intends to eliminate the national debt in 8 years,”

Market Commentary - Cumberland Advisors - Deficit, Fed, Post-Midterms

He then signed a $1.5T tax cut bill and a two-year spending deal that could push annual deficits above $2.1T, according to the CRFB (“Budget Deal Could Lead to $2 Trillion Deficits,”

“For the rest of his term, Trump plans to add $8.282T more to the federal debt, which will push the debt levels to about $30T in total (“New White House Report Shows Deficit Projections Have Doubled,” That represents a 41% increase from the $20.245T debt under the Obama administration. Trump will add as much debt in four years during a time of economic prosperity as Obama did in eight years while fighting a recession. That will make Trump the second biggest contributor to debt in history.” (“Obama: US spends more on military than next 8 nations combined,” Source:

Some of my fishing buddies like to write alarmist newsletters and wring their hands over debt. One of those newsletters hit my inbox on Saturday morning, November 3. That one forecast dire future outcomes.

My fishing buddy may be right someday, but I will bet my fly rod against his bait-casting device that, for the next few years, the increased debt financing of the United States will not be a problem for markets. That will remain the case as long as the US dollar is the unchallenged world reserve currency, as it has been for decades.

When you survey the world and look at other countries’ economic systems and current situations, the US emerges as the best or, if you are a hand-wringing detractor, the least troubled. It is true that the expansion of debt slows down productivity growth. Debt service, even at low interest rates, is an allocation of a cash flow away from growth investment in capital deepening. There, the newsletter writer was correct. But by itself, rising debt issuance will not trigger a debt-service crisis for the US.

Comparisons with Italy or Greece are dramatic. But they are neither helpful nor accurate. And they are not true of our political system versus European systems.

It is true that the US is likely to run deficits exceeding $1 trillion annually. It is also true that President Trump said one thing about the deficit and did the opposite. It is true that the cyclically adjusted federal deficit is probably a lot larger under Trump than it was under Obama. Of course, Trump will never admit such a thing. And expect no such admission from a Republican Senate, nor from a Pelosi-led House.

And it is true that we are approaching a debt-ceiling fight, which will break out shortly after the 116th Congress is sworn in on January 3. Note that the new Congress will commence this activity amidst the ugliness of a politically divided government. The coming debt-limit fight will occur in the shadow of the recent nasty midterms and as the 2020 presidential election cycle fires up in earnest. No serious deficit-reduction measures are expected to advance in the forthcoming lame duck session. If anything, the deficit will be increased by the outgoing 115th Congress if they have a way todo it

Estimates are that the US Treasury will end 2018 with a cash balance of $410 billion (source: US Treasury and Barclays). That balance will be reduced to about $200 billion by March 1, 2019. Note that a reduction of the Treasury cash balance acts as an increase in bank reserves since it is an actual transfer of the cash from the Treasury to the banking system. That’s right: the higher the Treasury cash balance at the Federal Reserve, the lower the excess reserves in the banking system and vice versa. Remember: The Fed acts as the banker for the Treasury.

The deficit is being financed mostly by the rising issuance of Treasury bills, so a small shock is coming to the short-term funding markets in the next few months. We will see this in the spreads among the various measures in the short-term, riskless end of the yield curve. We may also see the Fed have to make another adjustment in the spread between the upper end of the fed funds limit and IOER (interest on excess reserves) as rates press the upper bounds of the Fed’s policy target. Note that for many technical reasons the Fed’s task is becoming more and more difficult as the Fed shrinks its balance sheet.

There is a debate among observers about the Fed’s policy direction and an additional debate about the Fed’s trying to do two things at once. It is hard enough for the Fed to get one thing “right.” Yet this Fed persists in trying to shrink its balance sheet and raise the target policy rate at the same time. We think by March or April or May the Fed will have reached a point where the short-term funding markets will no longer have the luxury of those large balances of excess reserves. The timing is uncertain here, and the list of factors that could change things stretches longer than a page. That said, the short-term funding markets are already showing increasing pressures, albeit small ones. I agree with Zoltan Pozsar, at Credit Suisse, that the additional pressures will soon be apparent.

When we see these pressures surface, there will be many who point to the rising federal deficit as the cause. We can almost hear the chorus now. But that will not be the reason, in our view. The reason will be that the Fed is doing two things at once, with impacts that are likely to collide. Therefore the Fed will add to the confusion about causality. As Ben Bernanke rightly pointed out, the Fed will eventually have to increase the size of its balance sheet. Any shrinkage now is temporary and counterproductive for the longer term.

Will there be a policy change? Will the Fed stop shrinking its balance sheet soon? I would like to say yes, but I doubt that it will. The Fed seems hell-bent on maintaining its schedule unless some shock occurs. Why we might need the shock as a wake-up call is beyond me. Will a new Congress ask that question?

President Trump hasn’t helped matters by bashing the central bank, though the decisions of the Fed are not likely to be influenced by any bashing. Most of the central bankers that I personally know take their roles very seriously and see themselves as avoiding politics and focusing on policy outcomes. But they are also doing two things at once without really explaining how the two policies intersect and interact. The Fed hasn’t explained, for instance, the market impact of raising rates while forcing duration into the market. But that is exactly what they are doing, and that is why they are risking a shock.

It would help if the Fed could offer markets clarity on the pathway to normalcy in the US. My expectation is that we won’t get it. And the task of interpreting the Fed will be increasingly difficult. Key indicators to watch are the spreads among the short-term funding instruments in markets where credit risk is not the issue. In our firm we review them daily. We look for a shift of a few basis points as a sign of pressure. And we look for nuances in Fed policy changes.

For the average investor these are difficult tasks. They require a lot of data surveillance. One has to track spreads between T-bills and repo and SOFR and fed funds and IOER. For those who wish to dig deeper into this subject, there are discussions and serous research papers at the websites of the Fed Board of Governors and the twelve reserve banks. The NY Fed is the center of this daily activity.

In the management of bond and ETF portfolios at Cumberland, we rarely make changes based on these minor basis-point shifts in funding markets, but we do watch them carefully. Our clients’ portfolios are separately managed accounts structured with investment objectives that are not adversely affected by these very small shifts. The opposite is true for very large institutional portfolios. Still, for us the daily watchful waiting remains critical, since it provides early-warning signs of trouble.

Right now there is little pressure evident in the high-credit-quality funding markets. There is excess liquidity, though it is being gradually withdrawn. As of now, the federal deficit is easy to finance, and there is no rollover risk (that is, no risk in refinancing short-term debt).

We don’t expect such risk to surface in the US in our post-midterms period. My friend who likened the US to Greece and Italy is in error. They have rollover risk; we don’t.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio

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Dance of Fireflies

The modern Greek odyssey continues with a dance of fireflies. This particular version is dedicated to a different Homer. We are speaking of the late Sidney Homer and his treatise on interest rates. His book, A History of Interest Rates, graces libraries around the world. Homer’s great contribution to the history of finance and economics is his study of interest rate movements and interest rate levels from antiquity to his death.

Market Commentary - Cumberland Advisors - Market Commentary

Were Sidney Homer alive today, he would be rewriting his book, and the new edition would incorporate the interest rates we see in Europe, particularly in the Eurozone. The latest movements of negotiations between the peripheral weak Eurozone member countries and the credit worthy strong Eurozone member countries, like Germany and Finland, are geared to interest rates. The absurdity of that policy is clear to anyone who has studied interest rates over the course of several millennia.


The European Central Bank discussed a proposal which is not official, but has been debated in the press. It argues that the central bank should target the level of interest rates on sovereign debt in the weaker peripheral countries. In other words, the ECB should determine what interest rates are appropriate for the government of Italy to pay. Then enter the market and buy unlimited quantities of bonds until such an interest rate is sustained. The same would be true for Spain and other countries.


Picture the debate that sets the level of interest rates which are determined by an institution under the present circumstances where a country, like Italy, has a debt-GDP ratio rising, an economy shrinking and deficits still not under control.


The US had such an interest rate policy during World War II. In order to finance the war, the Federal Reserve maintained interest rates on US treasury debt at a constant level for over four years. The short-term interest rate on 90 day treasury bills was three-eighths of one percent. The long-term interest rate on US treasury bonds was two percent. The Federal Reserve purchased unlimited quantities in order to maintain those interest rates. Its motivation was patriotic. Its policy implementation was necessary. Our country was at war and fighting for its survival.


The Federal Reserve ignored the inflation rate during this period. At its peak, the inflation rate was in double-digits. The Federal Reserve ignored the fiscal policy. During that time, it was huge. Money was being borrowed and financed by the central bank. Savings rose within the country in order to be spent on a military operation necessary for victory.


Now fast forward to the condition in the world today. Most countries are not at war. Politically motivated circumstances are driving the economic conditions of nearly all major economies. Patriotism is in short supply; unity of national purpose has been replaced with politically-driven acrimony.  The financial system reeks of corrupt and distasteful behaviors. The short-term interest rate is being held by the major central banks close to zero. This is similar to what happened during World War II.


The ECB is discussing freezing, holding and stabilizing the longer-term interest rate and doing so in the weakest of its economies. In the US, we see the Federal Reserve using “Operation Twist” in order to hold, stabilize or determine longer-term interest rates. In Japan, the long-term interest rate has been so low for so long that it is becoming a basic assumption in ongoing life.


Greece is the ultimate firing line test now. The dance of the fireflies takes place between German cities, German government and German politicians trying to find ways to stop the bleeding that is feeding a Greek political system with unbalanced affairs. There is a trade-off. The German politician asks, “Do we draw a line in the sand and risk default?” Do we bend the terms, amend the agreement, alter the composition of the payments, accelerate certain benefits, and otherwise twist the structure so as to defer the inevitable?


We are witnessing a series of these questions that will take place in September. We are witnessing a troika determining whether to advance more money to Greece or not. We are witnessing the rolling refinance of Greek debt so that the debt held by institutions can be paid from advances from the same or sister institutions.


About €60 billion must roll soon. The IMF, ECB, etc. must contrive a mechanism to advance money to Greece. This allows Greece to make its payments to them or their financial siblings. This roll does not bring Greece any new money. Only a restructuring of Greek debt results in freeing up cash flow to use. But austerity requires Greece to tighten its belt while hunger rises. This is no easy task after years of economic contraction. European history is replete with failures after this approach was attempted.


The dance of fireflies continues in the Eurozone. The outcome is the ongoing increase of moral hazard.


Modern day Sidney Homer would have several new chapters in his book. The troika has replaced Troy of antiquity and the battle continues between the forces, including those that would introduce a deceptive horse into this mix. After Labor Day, the next round of Eurozone shock, anti-shock and market reaction will commence once again.

Cumberland is underweight in the Eurozone and takes a very hard view about getting paid.

The idea of extending credit to sovereigns, whether it is in Europe or in the US, is simple. If you loan your money to a government by purchasing one of their bonds, you want to be sure you are going to get paid interest and principal as agreed.


The drachma, the Greek currency, is over 3000 years old.  It was the most widely circulated coin in the world prior to the time of Alexander the Great.

Market Commentary - Cumberland Advisors - Greek Drachma

Readers may enjoy a few minutes of study about Alexander the Great.  His Macedonian army conquered Persia and much of the rest of the ancient world.  His education came from Aristotle, his tutor up to the age of 16.  He changed the political geography of the Balkans and the Mediterranean. See a few notes at the very end of this commentary.


Back to the drachma.


Since its reintroduction in 1832, all modern forms of the drachma have ended badly.  The single exception was the exchange of the drachma for the euro in 2001. That chapter of Greek history is being rewritten now.


The worst Greek hyperinflation was during World War II.  At its extreme, the Nazi-Italian occupation Greek government inflated at rates similar to those in latter-day Zimbabwe or the infamous Weimar Republic.  At one point Greece issued a 100,000,000,000-drachma note.  Greek monetary history also includes one previous failure in a currency union (the pre-World War I Latin Currency Union).


After WWII, Greece attempted to halt inflation by entry into the Bretton Woods fixed-currency regime.  They created a new version of the drachma by replacing the old one at a ratio of one new drachma for every 1000 old.  When the Bretton Woods structure suffered its demise in 1973, the new drachma declined in value.  It had been valued at 30 drachma to 1 US dollar at Bretton Woods entry (1954), but reached about 400 to 1 US dollar in the years prior to Greece joining the euro.  In 2001, when Greece was admitted to the Eurozone, the official exchange rate was 340 drachma to a euro.


Will there now be another new drachma?  If yes, what will it look like?


Money has three basic characteristics.  They are: (1) unit of account.  This is how we enumerate a price or a debt.  (2) Store of value.  This is the issue of “trust.”  Does money hold its value or does it lose value to inflation?  (3)  Medium of exchange.  This means acceptance, by others, of the money as a form of payment.


Nothing in Greek history suggests that the new drachma would qualify on any of these three measures.  Greek monetary history is one of default, inflation, and destruction of wealth when wealth preservation was entrusted to the government.  I have centuries of history on my side when I make this statement.


Of course, a new Greek government can try to force its citizens to accept a new drachma as payment of obligations issued by that government.  Greece may elect such a government on June 17.  Argentina used force to prop up the peso after it repudiated its governmental promise to maintain the peso at parity with the US dollar.  In the Argentine case, the peso quickly went from one to the dollar to three to the dollar.  Argentine citizens are still paying the price for their government’s monetary failure.


If Greece leaves the Eurozone and launches the new drachma, the internal outlook is for destruction of remaining Greek wealth, confiscation through taxation, high inflation, and monetary turmoil.  That is, a repeat of Greek history.


The () outlook outside of Greece is even worse.  Private holders of Greek debt have already been crushed and burned.  They are no longer involved in the decision making.  They avoid any Greek obligations and function on a cash-only basis or with secured or hedged letters of credit.  The Greek stock market has been decimated; its percentage decline exceeds the losses of American markets during the Great Depression.


The Greeks owe several hundred billion euros to European and international institutions.  That debt cannot be paid.  Holders of those obligations are mostly governmental institutions now.  Those institutions can hold obligations for a long time and can negotiate political changes in their structure.  Meanwhile, they can also defer the impact of default by postponing recognition of it while they negotiate.  In short, we are not worried about losses on Greek debt by the ECB, IMF, or others.


If Greece were to leave the Eurozone unilaterally, we expect that the post-euro Greece would have no market access for years.  With a new drachma, Greeks would function on a mostly cash-only basis in making their external payments.


Were Greece to exit, other European commercial and banking holders of Greek obligations would have to take more losses.  They already know these exist, in principle.  They would need to mark to market.  That means they will have charges against their capital and may need infusions of new capital.  The equity owners of those commercial institutions will suffer losses.  Many have already lost as the markets go on adjusting prices to reflect this risk.  These losers are the banks and insurance companies of Europe and others who are involved in the finance of the Eurozone.


The last element in this litany applies to contagion risk.  We already see contagion at work in Portugal.  Credit spreads are telling us that Portugal is the next Greece.  It remains to be seen whether the market is right or the market is overreacting.   We also see budding signs of trouble in Spanish and Italian spreads and even slightly with France.  The French benchmark 10-year bond now trades over 100 basis points wider than the 10-year German benchmark “bund.”  The lessons of losses from holding Greek sovereign debt are fresh.  Bondholders of the other countries fear repetition, with good reason.


No one knows whether Greece will actually leave the Eurozone.  Many are privately and contingently preparing for it while publicly saying they do not want it to happen.  Electoral outcomes are unpredictable, even though polling results influence markets.  In the end, Greece has already lost.  Europe has also lost but can still minimize further losses if it acts with congruence.  We do not expect that to happen.  It is not in the nature of Europe’s political leaders to reach consensus proactively. They do so when forced by market events.  We must think of European leaders as reactive, not proactive.


“When you’re in a hole, stop digging.”  Cite: U.S. News & World Report, 23 Jan. 1989. CVI. iii. 46 (headline).


The Eurozone’s leaders had the chance to stop digging when the Greeks restated their macro numbers after they entered the Eurozone.  Those leaders were publicly silent –privately enraged, as I heard with my own ears, but publicly silent.


Eurozone leaders had another opportunity to stop digging when the Greek government lost its high credit rating.  Instead they bent the rules and permitted Greece to maintain its collateral standing.   Eurozone leaders had repeated chances to stop digging, as the last two years unfolded.  Eurozone leaders have failed at proactive decision making.


They have another chance right now, but  they have so far failed to act decisively.  They continue to extend credit to Greece.  The present form is through the expansion of “emergency liquidity assistance” (ELA) by the Greek central bank, with the secret approval of the ECB.  Europeans fear contagion from bank runs that would collapse the Greek banking system.  Meanwhile, the ELA is only expanding the liability for the rest of the Eurozone, as it waits. At Cumberland, we are tracking the ELA continuously.  It is telling a story of accelerated deterioration.


Contagion risk is high and rising.  Banking runs in weaker Eurozone countries are likely to continue.  Why would any sane depositor keep her euros in a weak bank, when she could move them to a safer bank in another country?


My colleague and Cumberland’s Chief Global Economist, Bill Witherell, is in Europe and just finished several days at the GIC meetings, which included eight central bankers.  Greece and the other peripheral countries were an ongoing topic of discussion.


Bill emailed me his conclusion: “The decision for Greece exiting is really up to Greece. There is no provision in EC law for kicking a country out. It could be done with a unanimous decision by the EC heads of state.  The problem is that Greece wants to stay in, but the majority appears not to be willing to follow through with the austerity commitments already made.  They will not be able to meet their financing needs without further funds from their creditors.   The latter will be quite unwilling to continue to help if Greece refuses to keep its commitments.


“Is it possible we could see a messy restructuring/default but with Greece remaining in the Eurozone?  Portugal Is not Greece, no matter what the bond vigilantes may think. I think the Eurozone members, the ECB, and the Portuguese government will do whatever it takes to see Portugal through a difficult period. The same goes for Spain and Italy.  Incidentally, in the Sat. FT there was an article saying that over a long time period, half the time Greece was in a default/restructuring situation.”


Thank you to Bill, who responded to my email between airports in Cracow and Paris.  Bill will have more to say about Europe in the next few days.


So, when you’re in a hole, stop digging.  If you are not in a hole, don’t go there.


At Cumberland, we have avoided the “hole.”  We do not own peripheral Europe.  We have underweighted total Europe but do own some exposure in the north.  We are now worried that France can weaken, so we do not own France’s ETF.  We are more worried about Italy, the world’s third-largest debtor.  We remain concerned about the outcome in Spain.  We certainly fear a reprise of Greek tragedy in Portugal, although our base case is that it won’t end in a Portuguese default.  In any case we do not own Greece, Italy, Portugal, or Spain and are currently avoiding France.


As for the new drachma, it is not a panacea.


Some notes follow:

(1) The word panacea has its roots in the Greek word panakeia, which means “all healing.”  Such is the irony of language.

(2) Ancient Macedonia is not to be confused with the present day Republic of Macedonia, a part of the former Yugoslavia.

(3) Macedonian King Philip II, the father of Alexander the Great, united ancient Macedonia with successful military campaigns.  He created the platform for his son to conquer the world.  Philip’s success 24 centuries ago had two elements that were new to warfare at this time in antiquity.  He expanded the use of heavy cavalry.  Ancient Macedonia had the ability to support horses in larger numbers than more southern Greek agricultural states.  Philip incorporated heavily protected horses in the construction of his phalanxes (the battle formation used in ancient times).  Philip also added a long spear (sarissa) to the front lines of the phalanx.  It required two hands to hold and was about 18 feet long.  That allowed the first five rows of the phalanx to hold spears as they marched to face the oncoming phalanx, whose shorter spears meant only the first two rows of men could penetrate the opposition.

(4) The island of Delos is famous in Greek mythology.  It is also the original seat of the early Greek monetary authority.  After the Persian wars, the island became the natural meeting ground for the Delian League, founded in 478 BC.  Those congresses were held in the temple.  The Delian League’s treasury was kept on Delos until 454 BC, when Pericles removed it to Athens.  Thus, we surmise that the original Greek monetary policy was determined on Delos. It must have been successful, since the drachma was universally accepted at that time.

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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