String Them Up!

Fundamentals: In the late 1990s America ran a fiscal surplus because earlier in the decade bond vigilantes forced austerity down Congress’s throat by bidding up treasury yields in direct response to government spending. Last week every heavily indebted country on the planet saw government bond yields rocket up in classic vigilante fashion (including global titans America and Japan). Greece is the worst big spender among developed countries. Its bond yields soared last week by the greatest amount ever recorded. Greece offered the vigilantes a smoke and mirrors austerity plan. Unimpressed, vigilantes savagely pushed up Greek interest rates into the final hours of the trading week. Among the debtor countries only Ireland offered a credible austerity plan, slashing government worker salaries by 8%. Satisfied, the vigilantes lowered Irish interest rates in the latter part of the week. If Greece fails to take similar action, its interest rates will keep climbing until the possibility of default looms. At that point the IMF will step in, put together a bailout package, and take direct control of Greek finances. The Greek budget will then face cuts similar to the ones in Ireland. If the situation gets that far out of hand financial markets will probably take a big hit since Greece is a member of the EU.
America’s Congress did not offer the vigilantes even smoke and mirrors. Fat and stupid, it is passing an omnibus spending bill that increases discretionary spending by 12%, including a fat pay raise for Federal employees. This is on top of the trillion dollar healthcare bill, Obama’s 200 billion dollar second stimulus plan, and the Afghan military surge. America is not Greece. If Congress won’t cut government spending, then the Fed can step up Quantitative Easing (QE: the government buys its own debt by printing money out of thin air). In a normal economy QE will lower nominal interest rates but stoke inflation, thus raising real interest rates, doing more harm than good. Historically QE only works if an economy is stuck in low gear, mired in a severe recession, which is no longer the case.
All of the above is the reason why the stock market is no longer trading up on good news. Since March bulls have been talking about a “new normal” of permanently low interest rates and a very weak but steady recovery that pushes fiscal and monetary stimulus into asset price inflation, not genuine inflation. But the market is not trading down on good news either. Good news has weakened the dollar carry trade, bolstering the greenback, which has clobbered the price of oil, diminishing the threat of inflation. Does this mean that the events of last week represent a “new-new normal” where QE magically enables our spendthrift government to pile debt on top of debt forever or at least a couple more years? The answer resides in the action of bond vigilantes, which we can see by watching the yield on the 10-year and 30-year note. Trouble begins when the 10-year yield hits 4%. In the Wild West the original vigilantes liked to have hanging parties. String them up!