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Markets Demand Fiscal Discipline

Economic Notes for Monday, June 1st, 2009

The explosion in long-term interest rates is abating, but the warning from markets remains stark and bleak.

In one week the 10-year T-note blew from the 3.20s to 3.70s, now 3.50% but far from the 2.50-3.00% range Thanksgiving-April. An origination fee bought a 4-something mortgage until Wednesday, then 5.25% at the top, back toward 5.00% now.

Optimists and worrywarts found what they wished in economic data. Conference Board consumer confidence rose from the 25.3 pit in February to 54.9 in May; however, a normal-growth economy has a 100-125 confidence reading. Orders for durable goods jumped 1.9% in April, but only offset the downward revision for March. New unemployment claims held 623,000 -- off the 663,000 peak in early April, but no good.

Sales of existing and new homes stayed flat in April, at record lows. "A" quality loan delinquencies rose to 8.9%; all indicators for foreclosures are rising; modification programs are still small-number, and of those, re-defaults run 25%-60%. Low-priced homes in every market get auction-style attention; however, foreclosures at 50% of resales tells you everything you need to know about the non-foreclosure fraction. Unstable, not bottom, not bottoming. Higher rates make bottom impossible. Even before this week's rate-wreck there was still no up-tick in purchase-loan applications.

There are four reasons for the bust in long-term Treasurys:

1. In this ultimate Keynesian spasm, too many Treasurys are coming to market. Not so much the $2 trillion this year, or even the $1.5 trillion next year, but the flat refusal by the Obamanauts to adopt fiscal discipline in the out-years. On current "plan" our debt will soar from 45% of GDP to 75% in 2013, still ramping open-ended.

2. Everyone knows that inflation is a sure thing. The odds are 10:1 against, but there's nothing like last-war certainty. Breaking that fear will take time. The Fed could get us to Weimar or Zimbabwe by printing currency and dropping it in stacks on street corners, but in utterly broken credit conditions invented money is struggling slowly from the Fed to the corner, evaporating on the way.

3. The Green Shooters are equally certain that economic bottom has passed, and recovery has arrived. These people will change their minds sooner than inflationators.

4. The Fed at "0%-.25%" cost of money should anchor long Treasurys. Borrow at no cost, lever 8:1, a 2.50% 10-year pays a fantastic return, enough to offset damage in future reckoning. However, all of the bank-repair efforts have descended to black comedy: pretense, gaming, and deferral. The financial system is still loaded with bad assets and short capital -- no loans, no leverage of Treasurys, MBS, or anything else.

One quick corrective: mortgage demand collapsed on Wednesday. 70% of applications had been for refinance, and above 5.00% demand is zero. Another possible nearby corrective: a load of Agent Orange economic data next week.

The nightmare corrective: historians will study this Keynesian Limit the same way we have studied FDR's balanced-budget error in '36. If government over-borrows in a super-Keynesian attempt to stimulate aggregate demand, and long-term rates rise, at what point will higher rates choke off the benefit of stimulus? Answer: Wednesday.

The 1936 national debt had all the magnitude of an accounting error. The flinch from borrowing then was hair-shirt ignorance. When debt ran to 140% of GDP in WWII, it was soaked up by a nation on rationing, War Bond rallies, and nothing to buy on Iwo.

From California to oblivious Obamanauts, markets demand fiscal discipline. Until it is adopted, the high-wire hazard from spending cuts notwithstanding, each new auction of Treasury paper will be Russian Roulette.

The good news: spending limits might work, and well. "Aggregate demand" was the problem in the '30s, but not now. This is a balance-sheet catastrophe, debts in excess of assets. Solve the financial problem by modest borrowing, capital forbearance and guarantees, get credit going, and we can crawl out of this.