The Real Contagion Risk

Around here we like to track things from the outside in, as the initial movements at the periphery tend to give us an early warning of when things might go wrong at the center. It is always the marginal country, weakest stock in a sector, or fringe population that gives us the early warning that trouble is afoot. For example, rising food stamp utilization and poverty levels in the US indicate that economic hardship is progressing from the lower socioeconomic levels up towards the center -- that is, from the outside in.

That exact pattern is now playing out in Europe, although arguably the earliest trouble was detected with the severe weakness seen in the eastern European countries nearly two years ago. 

Because of this tendency for trouble to begin at the periphery before spreading to the center, here at headquarters we spend a disproportionate amount of our time watching junk bonds instead of Treasurys, looking at weak sectors instead of strong ones, and generally spending our time at the edges trying to scout out where there are early signs of trouble that can give us a sense of what's coming next. In this report, we explore the idea that Europe is the canary in the coal mine that tells us it is time to begin preparing for how the world might change if the contagion spreads all the way to US Treasurys (which is mathematically inevitable, in our view).

Why the US Should Care About Europe

At the very core of the global nuclear money reactor are US Treasurys and the dollar. If the dollar's role as the world's reserve currency wanes or even collapses, then the scope and pace of the likely disruptions will be enormous. Of course, we'll be glad to have as much forewarning as possible.

Accordingly, it is my belief that if the contagion spreads from Greece to Portugal (or Italy or Spain), and then to the big banks of France and Germany in such a way that they fail, then rather than strengthening the dollar's role (as nearly everyone expects), we should reserve some concern for the idea that the contagion will instead jump the pond and chew its way through the US financial superstructure.

While I am expecting an initial strengthening of the dollar in response to a euro decline, I believe this will only be a temporary condition.

The predicament is that the fiscal condition of the US is just as bad as anywhere, and we'd do well to ignore the idea, widely promulgated in the popular press, that the US is in relatively better shape than some other countries. 'Relatively' is a funny word. In this case, it's kind of meaningless, as all the contestants in this horse race are likely destined for the glue factory, no matter how well they place. 

While there are certain to be a lot of false starts and unpredictable twists and turns along the way, eventually the precarious fiscal situation of the US will reach a critical mass of recognition. Before that date, the US will be perceived as a bastion of financial safety, and afterwards everyone will wonder how anyone could have really held that view.

A good recent example of how swiftly sovereign fortunes can change: One day, everything was fine in Greece, which enjoyed paying interest rates on its national debt that were a few skinny basis points (hundredths of a percent) above Germany’s. A few short months later, Greece was paying over 150% interest on its one-year paper. 

What I am asking is this: What happens when the same sweep of recognition visits the US Treasury markets? Is such a turn of events even possible or thinkable?  Here's one scenario.

How Contagion Will Spread to the US

My belief is that someday, perhaps within a matter of months but more likely in a year or two, the US Treasury market will fall apart as certainly and as magnificently as did Greece’s. Here’s how that might happen:

Step 1:  As the global growth story frays, global trade decelerates, and the sovereign and total debt burdens of various countries drag at economic growth, fewer and fewer dollars will be accumulated and stored by various foreign central banks. The typical way dollars are stored is in the form of Treasury holdings. Because of this, several years of record-breaking Treasury accumulation by these foreign banks will grind to a halt and foreign Treasury holdings will begin to decline

Step 2:  The US government, thinking that foreign lending had somehow become a permanent feature of life and having consequently ramped up spending and borrowing to record levels, will find itself unable to adjust quickly, especially with an election year in sight. Federal borrowing continues amidst a sea of squabbling over meaningless, barely symbolic cuts to spending, even as official foreign demand for Treasurys wanes.

Step 3:  After it is recognized that the central banks are taking a breather from more Treasury accumulation, private participation in Treasury auctions begin to wane, with the bid-to-cover declining and eventually approaching dangerously thin levels. In parallel, Treasurys traded on the open market begin to creep up in yield, indicating that more sellers than buyers exist.

Step 4:  The Federal Reserve, having publicly committed itself to maintaining a zero Fed Funds interest rate through 2013 and therefore finding itself in the awkward position of having to save face, will be forced to funnel more money into the Treasury market. But because it is already committed to selling short-maturity paper in favor of long-dated paper, it does this by announcing another round of quantitative easing (QE) in some other asset class held by the sorts of financial institutions that will have no choice but to immediately park that thin-air money into Treasurys. The holdings of money market funds come to mind.   

Step 5:  The rest of the developing world, especially China, takes an increasingly dim view of the US reserving for itself the right to print money to buy government debt while admonishing other countries for doing the same. First, there are just verbal protests, but then more and more Treasury selling begins to hit the market. Wall Street, happy enough to make a few bucks by flipping Treasurys at the Fed’s bequest, now sees that there’s a lot more money to be made by selling Treasurys and even more to be lost by holding them. Selling of Treasurys, pushed by a shift in foreign perception of safety (and utility), begins to pick up.

Step 6:  As the selling picks up, the rate of interest that the US government has to offer in order to attract sufficient buyers to new Treasury auctions continues to increase. Forced by this circumstance, the Fed has to raise rates in order to appear as if they are in control of the process, when, in fact, they are (once again) merely following the markets.

Step 7:  As interest rates spiral higher, the amount of money that the US government (as well as state and local governments) must borrow in order to service rising interest costs creeps higher and higher. In other words, the more money the US government has to borrow, the higher the rate of interest they have to pay, which serves to force more borrowing, which makes the rate of interest go higher...and higher...and higher...each feeding the other in a classic debt spiral. This is the same dynamic that Greece is currently suffering through.

Step 8:  The interest rate spiral creates a fiscal emergency for the US government, where the only choices are between slashing spending enormously (which would serve to crush the economy, perhaps by 10%-20%, and driving tax receipts down, sharply creating its own dynamic of pain), or running out of money and defaulting on its bills, or printing money and accepting a steep fall in the international value of the dollar. Because slashing spending is a delicate and politically painful process, by default it almost certainly will not happen in time to prevent the interest rate spiral from occurring. As to the idea of running out of money, that is deemed an unthinkable option, which leaves money printing as the most likely option.

Step 9:  While it is the politically easier solution, money printing leads to the abandonment of the US dollar as the main reserve currency of the world. This does not happen very quickly, but neither is it a linear process. It proceeds in fits and starts, but the end result is that the US can no longer export dollars in exchange for things, and this alone changes everything. Long accustomed to being able to export dollars and import things, the US grew to view this historical oddity as an entitlement. But instead, it was a relic of circumstances, first of the relative position of the US after WWII, and second due to the temporary requirement that all oil purchases must be made in dollars. This ‘petro-dollar’ feature meant that any country wishing to buy oil first had to accumulate a dollar surplus. In short, this meant having to run a trade surplus, if not with the US, then with a country that had one itself. This allowed the US to export dollars while other countries had to export real things.

The Importance of Exercising Vigilance 

Keeping a close eye on the data is the key to determining whether or not this projected progression is underway or even likely. Of growing interest (and concern) to me is that we are indeed beginning to see several of the earlier indicators predicted above – notably, a decline in US Treasuries held by foreigners and growing signals that more government borrowing/money printing is on the way soon.

In Part II: The Flashing Market Indicators To Watch For, we look into the meaning of these early warning signs and go on to detail the list of specific indices to monitor for an indication of when a full-blown US Treasury market breakdown is imminent. We also explain why we counter-intuitively expect risk assets (e.g., the stock market) to take a nasty turn downwards in advance of such a collapse.

Click here to access Part II of this report (free executive summary; enrollment required for full access).

This is a companion discussion topic for the original entry at

Reasonable…in-line with views I’ve been developing for many, many weeks.  
Will add…besides financial…should see even greater volatility and instability in all areas (leave it at that…one example is Greece socially) similar to "Crisis In Confidence" per promoted in Reinholt and Rogoff’s book This Time Is Different. Particularly government(s) credibilities?

2 cents.

Nice job Chris.



The US government does need to sell treasuries in order to spend money. It does not matter if no body buys treasures for the government to spend. However,when none are bought other than by the FED and the principal banks, then the US government has lost credibility.

The US government never has to default on any payment. The problem is the law requiring Congress to allow more spending. If Congress does not allow it, the the Administration would be breaking the law, if it was to spend additional money. The US government cannot go bankrupt, it can only devalue the US dollar to the point where nobody wants to use it.

Dr Martenson would make a better electrician than I an economist.
What I understand is that everyone owes everyone else money. They owe more money than all the money (M1) on the planet. And now somebody (the bond holders?) are upsetting everyone by asking for their money. First they picked on the Greeks and they had no money. It has dawned on the bondholers of the world that they have been dudded.

Poof. No money. Deflation. Must print money. Problem is there is a delay between when the keyboard prints and when John Citizen gets it in his hand. The institutions like to indecently fondle it before handing it on. With debt going poof this delay is fatal.

Thought. Is Johnny Citizen important to anyone other than himself in this picture? Are the real economic elements institutions and algorithms?

I think I know now what they mean when they speak of "A crisis of confidence". I thought it had something to do with BO.

In 2008 silver dropped back because entities had to liqudate their PM holdings to cover their bets.
I wonder if we will experience the same thing again with the next discontinuity, or have the players learned their lesson?

[quote=Arthur Robey]In 2008 silver dropped back because entities had to liqudate their PM holdings to cover their bets.
I wonder if we will experience the same thing again with the next discontinuity, or have the players learned their lesson?
Great analysis by Arthur Robey about the time lag. As for silver, if it drops back, I’ll buy more of it!
Meanwhile, listening to NPR’s Market Place show in the background, I’m reading total doomsday reports from every blog or news source that is linked here at CM … Europe is doomed, they all agree. And meanwhile, Market Place is playing the upbeat tune in background as they summarize that markets had a great day today, because of optimiistic reports about a deal in Europe on Greek debt. (Then Market Place had some cutesy stuff about Greek tragedy, and I guess the idea is that Greece is just going to have to bend over and take it, either because Greek people are lazy and no good or because they made a great tragic mistake (joining the Euro?). I think that NPR is off the mark, it’s Greek fables they intended, not Greek tragedies – Aesop’s The Grasshopper and the Ants. But there’s a happy ending there, as Greek entertainers survive well playing for the German ants on vacation all winter, and everybody is happy.)
I would suppose that the markets of most importance to NPR are the markets in NYC, where it’s all done in USD, which is poised to gain off Euro’s loss, at least temporarily until "all fall down." So, shouldn’t Market Place say that markets had a great day today because of pessimism coming out of Europe about a deal on Greek debt?

I’ve been thinking that the Euro’s troubles will be good for the USD, but maybe not. I’ve also been thinking that the Fed won’t do QE3 – I mean, what for? (Tried that and it doesn’t work!) But maybe the Fed will do QE3, if under some other name.
Some are calling a current trend to be an overall inflationary rally. Everything is going up, because the major central banks are all going to ‘print’ more money, even China. (There’s talk that QE3 is a sure thing, although we’ve been hearing that it is to be called something else this time.) PM, stocks, oil … it’s all going up in whatever denomination you want to think about. Some think USD will gain from Euro’s problems, but some don’t think that the USD is going to gain against the Euro from all this. US consumers will suffer.
I’m coming from reading Peter Schiff (CEO of Europacific Capital) at (October 25)

I’m relatively new to economic and financial thinking on these topics and have an honest question…
The people in charge must have some way out in mind. No? I mean, really, no? They have to at least think they know what they are doing. So what is it?

I have looked for the answer to what it is and haven’t found much, or haven’t been convinced by it. Is there something that just isn’t being considered by everyone else?

What about the idea that letting the rest of the world collapse around the US will force everyone into Treasuries? Would that happen, and does that get us anything? 

[quote=Capire]I’m relatively new to economic and financial thinking on these topics and have an honest question…
The people in charge must have some way out in mind. No? I mean, really, no? They have to at least think they know what they are doing. So what is it?
I have looked for the answer to what it is and haven’t found much, or haven’t been convinced by it. Is there something that just isn’t being considered by everyone else?
What about the idea that letting the rest of the world collapse around the US will force everyone into Treasuries? Would that happen, and does that get us anything? 
"The people in charge" … I take that to mean the Federal Open Market Committee (FOMC) of the Federal Reserve System.
"Do they think they know what they are doing?" The answer to that question isn’t simple. For openers, it isn’t like Ben Bernanke (or Barack Obama) is running the show, although they may be in on the hustle. I’ll outline the way it works.
There are currently ten members of the FOMC, and right there we get into political controversy. Theoretically, the FOMC is composed of all seven members of the Board of Governors (the public’s members) plus five of the presidents of the twelve regional Federal Reserve Banks – those five members representing the banks, not the people or the government. Thus, the full complement of the FOMC is twelve, but that is short by two because of outstanding vacancies on the Board of Governors.
About the vacancies, check out article by Mark Thomas, ‘Why Do Federal Reserve Board Seats Remain Unfilled?’ (CBS ‘money watch’) from back in 2010. Thomas points out that when there are two or more vacancies on the Board of Governors,

"... it skews the balance of power on the Federal Open Market Committee (where monetary policy is decided) toward the regional banks. Many of the regional bank presidents are inflation hawks, more so than the Governors, so this may have affected the Fed’s policy choices."
The general dysfunction of Congress also gets into the act here, in particular, the Senate with its peculiar tradition of allowing a minority (sometimes just one senator) to hold up confirmation of presidential appointments. That dysfunction is possible because members of the Board of Governors are appointed by the president subject to confirmation by the Senate, which is subject to corruption by contributions and other favors from the banks. (To avoid this kind of thing, the American Monetary Institute's Monetary Reform Act would shift control of the Fed over to the Treasury Department -- cutting out control of, by and for the banks -- so at least we could know who deserves the blame when things get messed up.) In other words, right off the bat, we find the whole thing is drenched in politics. There's talk of reform of the Federal Reserve Act to avoid this kind of thing, where the bankers not only have a voice on the FOMC, but banksters can even possibly control it. However, in the present situation, things still may be okay, in that not all the regional bank presidents are necessarily anti-American ... some may be true pattiots and of sane mind. (The same may even be true of some of the public's members from the Board of Governors.) The point here is that a stalemate on the FOMC makes QE3 less likely ... unless or untiil it becomes so inevitable that no one can deny its necessity as an emergency measure. Keep in mind that, even if all the positions on the Board were filled, there still would likely be huge disagreements among members of the FOMC, because the problems are difficult and there can be honest differences of opinion. In summary, to answer the question, "Do they think they know what they are doing?" it's more like (1) they think they know what should be done, but (2) they are not generally agreed about what should be done, and (3) they are probably agreed only that they cannot really do anything effective, meaning they are passing the buck. That is, they are agreed that the solutions have to come from Congress (which is divided and dysfunctional, except that it can always be counted on to pass FTAs and other stuff that multinational corporations and other major campaign contributors want). Here's how I think this thing works. The Fed can create more money with which to buy T-notes. They may have no choice but to do this because China maybe is looking to bring down the USD as the world's reserve currency, and they may decide that reducing their holdings in T-notes would contribute to that long-term plan, and also because Japan is in need of money to rebuild after their tsunami-nuclear-melt-down disaster, and the most likely way that they can do that is to sell US Treasury notes since they hold a lot of those. Ideally, IMO, cuts would have been made in expenditures and taxes would have been raised by plugging loopholes in the Internal Revenue Code for multinational corporations ... whatever it might take to move toward a balanced budget. However, the way it seems to always work, for example, a part of the budget battle mass insanity has been Boehner's anti-American stand that eliminating loopholes is a form of tax increase and so loopholes can't be closed now ... and anyway the loopholes have been created by Congress over the past 20 years or more ... and the same reasons the loopholes were put into law is why they can't be removed. (As Buddy Roemer says "It's the money!") That's the trap. The Treasury has to issue T-notes. Foreign central banks may be selling T-notes for various reasons. Therefore, the Fed may have no choice but to create money to buy T-notes. (When the Fed creates money, that's called Quantitative Easing or 'QE'. There's already been QE1 and QE2, so now there's talk about QE3, but it might be under some other name.) It's pretty clear that the FOMC would like to avoid QE3 or at least put it off till later (like until 2013 or at least until after November 2012). The one thing that is being talked up right now is that the Fed might buy some more of the toxic mortgages held by the banks. That's being talked up by Daniel Tarullo, who is a member of the Board of Governors who was very active and influential in various offices during the Clinton administration. Probably, Tarullo is thinking that the regional bank members will go along with this idea, since it comes down to the Fed buying up the uglies in the portfolios of some banks. So, we can only hope that doesn't happen, especially since we may really need to keep options open for when the pressure is on for the Fed to buy T-bills to try to buy some time for the Congress to actually try to fix something at the level of fundamentals. I hope this gives you some idea of what an answer to your question might be. IMO, it comes down to anywhere ranging from (a) "Yes, they know that they are going to do nothing at this time because there is nothing they can do that will help, but they will stand by to take action if it becomes absolutely necessary in a total emergency," to (b) "Yes, they know that they are going to transfer more of the wealth of the USA from the people to the megabanks (and from there to various foreign interests). But, assuming that the FOMC doesn't buy Tarullo's sucker story, there is hope in that as the Euro zone fractures (that is, some countries may leave the Euro to go back to issuing their own currencies), central banks and people generally will turn to the USD not because they have enormous faith in the USD or the US economy, but just because it's better than the Euro as things look now. So right now everybody is waiting to see how the Euro thing plays out. Personally, I have my America First attitude, so I will be happy if the Euro zone fractures for real, leaving the USD a little breathing space. Also, since I don't have a banks-first attitude, I am hoping that Tarullo's ideas will be squelched by Bernanke and four or more other members of the FOMC. Since Tarullo is one of the public's members from the Board of Governors, I am hoping, not without reason, that some of the regional bank presidents will act in the interest of the country and of smaller regional banks. In other words, I am hoping that the FOMC and the Fed will do nothing, and somehow ... God Bless America!  

I can’t believe that our crooked politicians are stupid enough to watch this country fall apart unless they want it to fall apart to advance their schemes. I think when everything falls apart "the powers that be" will tell the populace that they can no longer pay for Medicare, and all the other programs redistributing our wealth, UNLESS they agree to accept a global government. Since the majority of the people in the USA are on the dole in some form, most of the populace wil grudgingly accept the new world order. I would much rather believe that they’re stupid.

Somewhere in these steps, I would expect that the government would change retirement/401K rules and require that citizens hold a portion of their retirement in treasuries at an interest rate that looks attractive compared to a recently orchestrated stock market crash. Doesn’t Japan’s citizens own a large portion of their countries debt?
So US citizens will help stop the decline of treasury purchases from foreigners. The government does have this control, doesn’t it?

If Europe collapses and that causes a rush of money into dollars, how much breathing room does that really give the US? Obviously it must be dependent on how much money we are talking about, and it doesn’t solve our debt problems. But what does it get us?

John Mauldin has met with politicians (D’s, R’s, and Lieberman) and has indicated that behind closed doors they know exactly what is going on.  IMHO, from their perspective, a sudden crash will provide them with the cover they need to advance their agenda.  FWIW, I suspect that there is one and only one agenda.  What they don’t want to do is watch a repeat of the French Revolution while they are in office.

I think we are comparing notes here, and that’s why I appreciate intelligent comments.
About retirement funds I’ve heard a lot of speculation about the government wanting to require pension funds to get into T-notes. That’s what the Social Security Trust Fund already does and has done for a long time. China and Singapore both have more-or-less mandatory savings programs for all their working people, so that investments are made in China or in Singapore respectively. (Of course, much of US investment money also goes to China and Singapore.) I’m not sure how 401K rules could be changed, or what that might do, or what changes in those rules I might like to see.
Definitely, I agree that If the dollar gains from a fracture of the Euro zone, that won’t solve anything long-term for USA, but it might give us a little breathing room … assuming that somehow political leaders could get together about something positive that makes sense … which seems doubtful.
I wish we had more transparency in government (and in finance). But we don’t, so we are left to guess. As far as government goes, my approach is to forget about ‘the government’ or ‘the politicians’ or ‘Conventional Wisdom’ and look at functional components of the governmental system. That means the NSC, FOMC, IRS, SCOTUS, (as well as the Congress), and so forth. It’s hard to know how much of what’s visible is posing – charades put on to confuse or distract us –  but I think that we can take the system apart and see either how the hustle is being run on us or … here’s where it gets problematic … how We the People maybe can influence actual decisions.  I do believe that there is a lot of divergence of opinion among the political (and financial) elites – both about what is happening and about what needs to be or can possibly be done about it.
There’s more than enough reason for folks to be very, very cynical … and we are! And then it’s pretty obvious, the elites, the politicians, are at least as cynical as we are… Anyway, many of us are becoming what David Icke calls ‘street wise’ in his video ‘Essential Knowledge for A Wall Street Protester’.
(BTW: I am neither endorsing nor repudiating Icke’s views, but I found the video to be worth viewing.)