Knock Knock Knocking on Austerity’s Door

Conclusion: Today’s proposed federal employee pay freeze by President Obama is an early step in what we expect will be increasing austerity over the coming years.  American Austerity is bullish for the U.S. dollar.

 

Positions: Long the U.S. Dollar via the etf UUP

 

In early July, we announced our Q3 2010 investment themes, which included Bear Market Macro, Housing Headwinds, and American Austerity.  On the last theme, we presented at the time that due to burgeoning debt and deficit issues domestically, the U.S. would have to implement fiscal austerity measures.   At the same time we noted in one of our slides that some of the PIIGS in Europe were leaving the trough and implementing aggressive austerity issues, which was bullish for the Euro and bearish for the U.S. dollar versus the Euro.

 

In the chart below, we’ve highlighted the U.S. dollar index going back 9-month.  As it shows, the U.S. dollar weakened versus the Euro following our presentation in July and then began aggressively strengthening ahead of and in conjunction with the U.S. midterm elections where the Republicans gained 63 seats in the House of Representatives.  The massive shift in political power was and is an indication that there would be, at least, an attempt at implementing austerity measures domestically.

 

Knock Knock Knocking on Austerity’s Door - 1

 

Earlier today, President Obama introduced a preliminary austerity step as it relates to the pay of federal employees.  Obama is proposing to freeze the pay of federal employees for the next two years.  Not surprisingly, in the current politically-charged environment the response to this pay freeze was mixed at best.  Speaker Designate John Boehner (R-OH) responded with the following:

 

“I welcome President Obama's announcement, and hope he will build on it by embracing much-needed steps to reduce both the size and the cost of government, including the net federal hiring freeze Republicans propose in our Pledge to America. Without a hiring freeze, a pay freeze won't do much to rein in a federal bureaucracy that added hundreds of thousands of employees to its payroll over the last two years while the private sector shed millions of jobs.”

 

The message from Boehner, the defacto leader amongst elected Republican politicians, is clearly that they will be looking for more austerity measures as the new Congress opens in January.

 

The reality is, though, independent groups have analyzed the Republican Pledge to American and it, too, appears to fall short as it relates to reducing the deficit.  In the chart below, which appeared in Reason Magazine online and was put together by the Congressional Budget Office, the deficit is looked at as if the Pledge to America were fully implemented.  In aggregate, while spending does narrow, it is only marginally and federal government revenue is not projected to increase, so the outlook for the deficit, and growing federal debt balance, does not change dramatically.

 

Knock Knock Knocking on Austerity’s Door - 2

 

While the U.S. dollar will continue to strengthen with incremental American Austerity measures as we are seeing proposed today, the dollar will eventually require some dramatic measures to sustain its climb and for us to remain long term bullish of the U.S. dollar.  While their report was widely derided from the left (too much cutting in spending) and from the right (too many implied tax increases), the Presidential Fiscal Commission lead by Alan Simpson and Erskine Bowles presented a number of dramatic proposals to narrow the deficit, which included: 

  • Index the retirement age to longevity -- i.e., increase the retirement age to qualify for Social Security -- to age 69 by 2075;
  • Index Social Security yearly increases to a lower inflation rate, which will generally mean lower cost of living increases and less money per average recipient;
  • The co-chairs suggest capping both government expenditures and revenue at 21% of GDP eventually;
  • In their second plan, they would increase the personal deduction to $15,000, create 3 tax brackets (15, 25 and 35%); repeal or significantly curtail a number of popular tax deductions (including the state and local deduction and the mortgage interest deduction); and eliminate other tax expenditures;
  • They also suggest raising the federal gas tax by 15 cents per gallon;
  •  Eliminate all earmarks;
  • Freeze federal worker wage increases through 2014; eliminate 200,000 federal jobs by 2020; and eliminate 250,000 federal non-defense contractor jobs by 2015; and
  • Reduce procurement by 15 percent, or $20 billion. 

While today’s proposal by President Obama is incremental, for austerity to be long term bullish for the U.S. dollar it will require more dramatic and politically unpopular measures such as the ones outlined above.

 

Daryl G. Jones

Managing Director