Bottom Falls Out As Bond Yields Surge, GM Bankruptcy Looms

There's a problem with the government borrowing trillions of dollars to finance its various bailouts, stimuli, military and domestic operations. All that money has to come from somewhere and somebody, and the buyers will undeniably demand higher yields.

That became evident today as the government auctioned off $35 billion worth of 5-year notes. Stocks traded in a narrow range, with the Dow consistently below the unchanged mark and the NASDAQ trading marginally in the green, up anywhere from 5 to 12 points in the morning and early afternoon. At 1:30 pm, however, the bid fell off on all exchanges as the Treasury auction wrapped up. While the Wednesday auction was well-received, speculation was widespread that an oversupply of US government debt would have deleterious effects on any kind of recovery. Treasury is selling $26 billion of 7-year notes on Thursday.

The Dow dropped more than 150 points from 1:30 pm to the close of the session.

Dow 8,300.02, -173.47 (2.05%)
NASDAQ 1,731.08, -19.35 (1.11%)
S&P 500 893.06, -17.27 (1.90%)
NYSE Composite 5,823.56, -113.02 (1.90%)

As bond prices fall, yields rise, making bonds a more attractive alternative than stocks. The other effect of rising yields is that of making loans more expensive, especially for mortgages and autos. Higher interest rates threaten any recovery, whether one is in the cards for later this year or not. They are also by nature inflationary, adding cost at the producer of the supply chain.

In the short run, higher interest rates and inflation is exactly what the Federal Reserve and Treasury are after. Deathly afraid of the long-run effects of deflation, all of the various deficit-spending plans and aid to business and state governments have been designed to keep the bubble from bursting, to reflate the economy with massive infusions of currency and debt.

The problem for the best and brightest in Washington is that they can't have it both ways. The natural process of business failure, austerity and reallocation of assets - though inherently deflationary in the short turn - would have been painful, but swift and healthy long-term. The actions taken by the Fed and Treasury, designed to rescue failing institutions and keep government spending at current growth levels, have proven to only prolong the recession and threaten any incipient recovery with now-evident, profoundly inflationary aspects.

Another specter of massive government borrowing is the crowding out of private investment. Monied interests are likely to trend toward the safety of Treasuries rather than taking riskier positions on corporate issues. That also is an impediment to private sector growth, from which any recovery must spring.

Clearly, it is time to re-examine the efforts of the Fed and the Obama Administration. It's been four months since the inauguration, and, despite widely-reported "green shoots" and "positive signs" of the recession slowing, there is still no hard evidence that the economy will be in a recovery position later this year. All along, the American public has been told that the recession would be over by the third or fourth quarter of 2009, but, with those dates fast approaching there has been no job creation, no meaningful middle class tax break, and no stopping the continuing decline in home prices nor stemming the wave of foreclosures that has now become mainstream.

Government intervention in the economy has produced nothing except a temporary reprieve for insolvent banks and for the banking system as a whole, while adding mountains of debt to the already unserviceable load in place before the crisis. The federal government will eventually end up owning most of the largest banks, the auto companies and various other "too big to fail" industries. All of this is predicated on the notion of keeping the economy on a firm footing, meaning keeping hundreds of thousands of overpaid autoworkers at make-work jobs while nobody is buying autos, and bankers counting their billions without lending any to suffering small businesses.

The Federal Reserve has already bought up more than $160 billion of Treasury issuance. They've committed to buying a total of $300 billion, but there's no doubt that they'll have to pony up much more than that in order to keep the economy adrift. At some point, the wisdom of piling up even more massive debt has to be brought into question. That point may come sooner than anyone expects. Bond auctions in the UK and Germany have already failed, with a paucity of buyers for government debt instruments. The same could have already occurred in the US, had the Fed not engaged in its policy of quantitative easing. that is, buying up the debt with money created out of thin air.

It's a policy doomed to failure, as has been the case forever and ever, so be prepared for massive disconnects in the market, an absence of valuation rigor, inflation and deflation at the same time in different areas, and an overall failed economy which will finally bottom out sometime in 2011 or 2012, and not a moment sooner.

NYSE Volume 1,335,881,000
NASDAQ Volume 2,166,732,000

On the day, declining issues overwhelmed advancers, 4246-2227, wiping out most of Tuesday's illusory gains, and new lows maintained their long-standing edge over new highs, 68-62. Volume was only slightly better than yesterday's subdued level.

Oil gained $1.00, to $63.45. Gold gained a dime, to close at $955.20, while silver recorded the best showing of the metals, up 27 cents, to $14.87, an eight-month high.

General Motors executives announced that the offer to bondholders - to swap debt for common stock - met with an undue amount of resistance. This should have come as no surprise, since the company was offering bond-holders a mere 10% stake in the company, when the financiers were seeking an equity ownership position of between 50 and 60%. Instead, GM is likely to head down the same road as Chrysler, into bankruptcy, with the government ending up owning 60-70% of the company and the union picking up 15-17% of ownership. The government of Canada is expected to pick up less than 5% ownership.

in the end, the deal for GM is poorly designed, the goal only to keep from sending more than 200,000 UAW workers into the unemployment roles. There is no genuine plan to produce better autos, shave costs or limit benefits in an effort to become more competitive. General Motors will go down in history as the nation's largest bankruptcy, and the legacy will be that the US taxpayer will subsidize the jobs of hundreds of thousands of workers, in addition to paying lifetime health and pension benefits to millions more.

Existing home sales showed an increase for April, but the price of homes purchased was lower, affected by the thousands of foreclosed homes on the market. The stock of available housing continued to increase as well, another drag on home prices, which have fallen every month for the past two years running.

New home sales figures for April will be released on Thursday, along with continuing and new unemployment claims. The result of the $26 billion Treasury auction of 7-year notes will be closely monitored as well.

Today's sharp sell-off is the best evidence yet that the rally is over and stocks are set to fall and eventually retest March lows. The entire process could take as long as 6-9 months - or sooner - but the stage has been clearly set.