A recent AP article by Martin Crutsinger introduces and then answers the question "How did (the) $1 trillion deficit happen?" (see full AP article). Some highlights from the article include:

• The government's annual budget deficit has topped $1 trillion. With three months left in the budget year, it will get even worse. The administration is projecting that the deficit will hit $1.84 trillion for the current budget year. This is four times the size of last year's budget deficit.

• The deficit spending began with the 2001 recession, and got deeper with the 9-11 terrorist attacks as war spending started to ramp up.

• Until 2008 the deficit had been shrinking, hitting a five-year low of $161.5 billion in 2007, but was followed by the record deficit of $454.8 billion in 2008 as the current recession and financial crisis hit.

• The size of the deficit started to ramp up with the initial $700 billion TARP (about half spent in 2008, half in 2009), along with the recent $787 billion economic stimulus.

• In addition to stimulus spending,"automatic stabilizers," such as food stamps and unemployment compensation, are also increasing. Government outlays are up 20.5% through the first nine months of this budget year.

• All of this spending is occurring just as tax receipts are falling. Government revenues have fallen by 17.9% during the October-to-June period compared with one year ago.

• While large in dollars, current deficits are still not the largest in terms of GDP, but are the largest outside of WWII. Currently, the CBO is forecasting the budget deficit will equal 13% of GDP. As a comparison, the deficit was 6% of GDP in 1983 as we moved out of another recession and ramped up cold war spending, and 30.3% of GDP in 1943 during World War II.

• The CBO is projecting that the deficits will remain large for the foreseeable future, coming in at $1.43 trillion in 2010 and not falling below $633 billion over the next 10 years, ultimately adding $9.1 trillion to the national debt.

To tackle such deficits and debt, either spending needs to be curbed, or tax receipts need to increase - and quickly. Either way, the debt needs to be dealt with (see previous post), but the exit strategy will require hard choices (see Greenfaucet article). Given continued weakness in the economy, along with both health care reform and new global warming initiatives (such as carbon trading) on the docket, it does not appear that spending is going to slow down anytime soon (see previous post). The leaves tax increases on the wealthy and corporations, or additional tax cuts such as those recently targeted for the middle class. Expect the Supply Side - Keynesian debate to begin in earnest once again.

In the wake of the 2008 financial meltdown, it was easy to look the other way as governments and regulators considered nearly every course of action for keeping the engines of the economy from totally falling off the tracks, let alone from moving too fast in the wrong direction. But now, after massive stimulus spending, failures, and private-company ownership stakes, governments are dealing with numerous unintended consequences, forcing them to perform a difficult balancing act between immediate stimulus and long-term growth and stability.

This is now becoming evident in the Treasury market, where rising interest rates are putting pressure on the Fed's plan to bring down borrowing costs and help revive the housing market (see Bloomberg article). Mortgage rates, which have been increasing recently (see Bloomberg article and Reuters article), are now reaching high enough levels (if 5.25% is high) where they are beginning to decrease the number of new refinancing, not to mention making new home purchases more expensive and less attractive. While the increasing yield curve has been good for the net interest margins of the banks, the higher rates are coming at a bad time. It was recently reported that the number of homeowners who are getting behind on their mortgages is increasing, causing a spike in foreclosures (see NY Times article). Also, while the median price of a new home was up 3.7 percent in April, the general longer-term trend is still down, and will require a few more positive months to confirm a reversal. Sales of new homes also rose less than expected in April, with a downward revision of the March figures adding additional concern. Durable goods orders did see their largest gain in 16 months in April, but the March number was revised down sharply, causing concern for the accuracy of the current April reading.

Commodities and commodity-related stocks, on the other hand, have been rallying, with gold marching towards $1,000 an ounce, and oil rising above $65 a barrel (see WSJ article), up nearly 50 percent over the last five weeks (see Reuters article). The moves have come in part due to the falling greenback, with the dollar index down 10 percent over the last 3-months. Higher commodity prices have helped resource-rich emerging markets, lifting specific international indexes and causing a rally in emerging market bonds as the higher prices reflect an improved outlook concerning these nations ability to repay their debts (see Bloomberg article). Yet domestically, rising crude oil prices may slow down consumer spending as U.S. consumers find they once again have less disposal income (see Reuters article). Further increases in commodity prices, especially crude oil, will certainly draw concern from the Federal Reserve as it wrestles with the balancing act of growth and inflation, and subsequent worries about stagflation, making it difficult to raise rates. Capacity utilization is still low enough to make one believe that broad-based inflation is at least a year away, yet higher gasoline prices will influence consumer spending - which is vital to GDP and growth - with higher market rates adding extra pressure on spending.

In the area of "the news is good since it was not as bad as expected" camp, reported revisions highlight that GDP only contracted 5.7 percent in Q1, less than expected and previously reported, while corporate profits after taxes increased by 12.9 percent after falling 28.4 percent in Q4 (see WSJ article). Yet, not everything is rosy. Within the last few days, Tiffany posted a 64 percent drop in Q1 earnings, as margins slumped (see WSJ article). Cintas, the uniform maker, gave a weak Q4 outlook, saying that it also expects to have another round of layoffs, bringing its total workforce reduction to 12 percent over the past year (see WSJ article), and signaling further expected weakness in the broader labor market. As for technology, Dell warned that the PC market has not yet hit bottom (see WSJ article). Isolated, insignificant, and cheery-picked? Possibly. But certainly cause for concern.

All of this leaves the Fed and the Treasury with a difficult balancing act going forward. Fortunately for the Fed, or maybe unfortunately depending on your perspective, they may be off the hook, as investors and the markets take action themselves, and in the process drive up Treasury yields on debt and inflation fears (see Financial Post article). As equities enter the summer and currently appear to be stuck in a range as traders collectively make a market, the Fed may also find that it too could benefit from a little monetary consolidation. Unfortunately, the dollar, Treasuries, and commodity prices seem to have a mind of their own, with traders spotting the handwriting on the wall, and taking matters into their own hands. Quite possibility, the inflation train may have already left the station. Maybe the most the Fed can hope for is to make sure it simply arrives later than expected. Even those that feel inflation is a distant reality, see it as a reality, nonetheless. As investors and traders, we can prepare, and maybe make a little money along the way. Gold and commodity traders, as well as those shorting the dollar, are off to a good start.

With leverage no longer propping up demand, many analysts point to signs that we are either currently in, or are approaching a deflationary period, with some expecting this period to last up to 12 to 18 months (see Investment News article). Gary Shilling, who has written a couple of books on the topic of deflation, believes the period of deflation could be much longer, on the order of 5-10 years. In addition to providing a signal of lower consumer spending, and subsequently lower GDP, deflation also increases the impact of debt in real terms for both corporations and consumers. As for investment plays, analysts recommend looking at utilities, agricultural, and high-quality and in-demand consumer staples, in edition to U.S. Treasury bonds and good old fashion cash.

Today I got a chance to watch a little more of CNBC and other financial news shows and noticed a few things. First, there is a growing chorus about whether or not we have reached a bottom in the financial companies, and the market in general. There is a lot of talk about how "just think, if you had bought Fannie or Feddie or JPM or LEH last week, you would be up x%." It is common to do "what if" scenarios, but the coverage seems to be a little more intense today.

There was also a comment today on CNBC from Bill Seidman that was interesting. When asked about the recent actions of the Treasury Secretary, he mention that while current moves could positively affect the market near-term, even over the next year, the proposed actions are a longer-term disaster. He gave the analogy of how Secretary Paulson was running the Treasury like he ran Goldman Sachs, making sure he makes his numbers next year. Great stuff. While not mentioned by Seidman, you might also be able to make the same argument regarding the Fed, which seems to be managing quarterly GDP numbers and not focusing on controlling inflation and supporting the dollar for fear of occasional lower growth.

The numbers are out and the market reaction is somewhat expected. The ADP Employment number was higher than expected, coming in at 10K when the market expected -60K. Big miss? Well, yes, but as we have mention before, the ADP number is somewhat unreliable and at times difficult to predict. It has been right on at times, but also so far off that it loses some predictive power. The futures increased slightly on the news, but the "rally" was muted, probably somewhat due to the reliability of the number, somewhat due to other news coming out.

The GDP number showed the economy grew at 0.6% in Q1, matching the 2007 Q4 rate. The market expected 0.5%. Take that Recession! Of course, taking out the exports and trade, the GDP was negative, but this was also expected. Given that there are two more opportunities to revise this number over the next two months, and the little room for movement, a negative Q1 GDP is still possible. Inventories rose $1.8 billion, which was only a slight increase compared to the increase of $30.6 billion in Q3, and the $18.3 decrease in Q4. Certainly not as bad as some expected. The market response, while getting a short bump in futures after the news, was also muted, as with the ADP numbers.

Also of interest in the GDP report is how the PCE price gauge rose 3.5%, with the core at 2.2%. The core number continues to be in range but high enough to give the Fed a reason for pausing. Durable goods purchases fell 6.1%, while non-durable spending was down 1.3%. I am sure these numbers are not a surprise to the automotive companies. Residential fixed investment, i.e. housing, was down 26.7%. Ouch. Exports rose 5.5%, imports up 2.5%. No doubt crude oil contributed to the imports.

Back to being on hold for now while we wait for the Fed.