Why The Fiscal Cliff is Irrelevant

While there has been much talk about Fiscal Cliff and it's importance, the critical numbers (US Balance Sheet and Fed Interest Rate) tell us clearly that we fell off the cliff long ago and that the probabilities of higher interest rates moving forward are the greatest threat to the US Economy and our country's ability to pay current liabilities.

The math and probabilities suggest to us that in the near term (within 3 - 5 years), the US will be forced to restructure it's debt in some form.  This will have a significantly negative effect on the the purchasing power of the US dollar and will likely push the US into an extended period of negative growth.

By the CBO's own estimates in 2010, they projected interest rates to rise to 4% or 5% by 2015.  What they didn't anticipate was Government Expenditures continuing to rise 3x faster then Revenue.  With Bernanke's last announcement that he would keep rates at zero until 2015, he has set in motion and almost certain continuation of comparably rising expenditure/income ratios for the next 2-3 years.  This at the end 2015 would leave us with a debt in excess of $20 Trillion.

We believe the single most dangerous belief in the US right now is "That the Fed will always be able to control interest rates."  

With interest rates at zero, rates in the future can only go up.  There is 100% probability of rates rising in the future.  The only unknown variables are, "When will they go up, and "How far up will they go?"

If interest rates hit 5% in 2015, with a $20T debt bill, and without any significant increases in revenue, our annual interest expense of (5% x $20T = $1,000,000,000,000) $1Trillion will likely take up between 25% to 35% of central government revenue.  (We're close to 11% right now)

Until recently, America had never experienced being on the wrong side of compound interest. As of today we're on the wrong side of that equation and with a principle of $16,500,000,000,000.  Now imagine being on the wrong side of that bet with the largest accumulated debt in world history. That is the simple math, and those are the facts.  To believe there will be no significant consequence for our gross negligence is delusion. For the Fed to believe that it can control interest rates indefinitely while disregarding elementary math is fiscal suicide.

We have marked up the CBO balance sheet below to note the key data points we'll be watching of the next 24 months.

1. Interest Expense: We feel this is the single most important data point as it's penalty of failure will cause the most damage.

2. Taxes on Personal Income: We believe the CBO estimates are grossly exaggerated and will watch closely to monitor.

3.-4. The CBO somehow projected taxes on personal income to increase 25.37% from 2012 to 2013 (1123B to 1408B), despite a projected GDP of sub 3% and lack of any political will to raise taxes.  Unless the CBO is accurate with that revenue projection next year, the entire sheet becomes completely useless.  We have our bias, but will wait to see how it plays out.

5. (See Fed Interest Rate Chart): This will be the key to watch. It's important to not that with every 1% increase in interest rate the US annual interest expense increases $160,000,000,000.00.

Summary:  In the most simple terms, we see a 100% probability event on the horizon - Rising Interest Rates.  We want to be on the right side of that probability.  While we expect that event to happen, we remain patient and will continue to watch the events unfold that would create such a scenario.  At this point, political inaction will still provide the anticipated outcome as, at this point, there is nothing significant anyone can do to halt to current trajectory of expenditures over revenue.  Congress has certainly proven that over the last 4 years and we expect them to continue the same.

Contrary to conventional belief, not even the United States of America is immune from the laws of math, especially, "Compound Interest." 

What everyone will get wrong is the timing.

Over the last 3 years we have learned some very valuable lessons, the most important of which can be summed up in this statement, "Never underestimate what an addict will do for his next 5 fixes."

Asset Bubbles are built on "Delusion winning over Common Sense"

That being said, we realize that we live in a new era of artificial stimulation that has now reached every facet of our culture, society and monetary system.  For the traders and risk managers of the future, an acute understanding of the psychology of addiction will be a definite advantage.

Latest Copy (March 2012) of The Congressional Budget Office Projections of Federal Receipts and Expenditures in the Framework of the National Income and Product Accounts.