The markets have been choppy over the last couple of days. This is hardly surprising, with one of the most bizarre quarters in living memory drawing to close. To say recent indicators are a “mixed bag” is an understatement Consider the following (hat tip, Dave Rosenberg, Gluskin Sheff):

• British GDP shrank 2.4% in the 1Q (more than the 1.9% shrinkage expected)
• The VIX – a widely used measure of market volatility is – fell 25 points. But it’s still 25% higher than average.
• US equity trading volume is also down – signaling a lack of demand… and a possible sagging in the recent bear market rally
• US Treasury yields have remained more or less unchanged over the month of June despite the boys at the Department of the Treasury flooding the market with an impressive $176 billion in new issuance
• Crude oil prices are up over $71 a barrel. Meanwhile, the IEA has lowered its forecast for oil consumption. (There is enough storage for 62 days of global consumption – 10 days above Opec’s stated goal.)
• June auto sales are will come in at about 10 million units annualized. This is less than 50% their peak and roughly back at levels last seen in the 1960s.

Rosenberg writes that “the crisis at the lower levels of government in the US is now so intense that as many as TEN states may not have a budget prepared for the fiscal year that is about to commence next month!”

Wow!

Notes faithful will be aware that we view the fiscal crisis in California as a precursor of what’s to come in America. The mechanics of this are very simple. The government spends too much money out of an empty pocket to appease and please. It relies on a just about half of the population (according to the IRS the top 50% of earners pay 97% of income taxes) to contribute the majority of the tax revenues. This upside down pyramid eventually topples (revenues shrink while spending increases), and the government is thrown into a “budget crisis” (which is really a spending crisis by a different name).

The US federal government isn’t far behind state governments (a) because it has a larger tax base to rely on and (b) because it can borrow seemingly infinite amounts of money on the international debt markets thanks to the dollar’s status as world’s reserve currency (foreign governments and banks need dollars to buy a wide range of commodities, which are priced in the US currency).

But one day (sooner rather than later in our humble opinion) foreign buyers of US debt wake up and realize that huge increase of dollar-denominated debt on the market is causing the value of the buck to decline… and they look for alternatives.

This is happening already. China and its fellow “Bric” nations, Brazil, Russia and India are already vocalizing their discontent with the dollar-pegged system. The problem is they don’t yet have an alternative mechanism to the dollar. But they’re working on it. And when they come up with an answer to their dilemma, $174 billion in Treasury bonds a month will no longer find a happy home. The feds will have no alternative but to raise yields to attract investors. Higher yields mean higher borrowing rates overall, which mean you can forget about a sustained recovery or a return to the golden years of US economic dominance.

According to Rosie, the situation in the ten problem US states “is so acute that state governments are now threatening to go after unused gift cards for sales revenues — affecting $7 billion of income for the retailing sector.”