Currencies | May 29 2009
By Greg Peel
“There continues to be strong demand for longer duration Treasuries,” said Dallas Fed president and FOMC voting member Richard Fisher on Tuesday. The recent surge in the yield on the US 10-year bond, from 2.5% in March to 3.72% on Wednesday, brings this statement into question, however. But Fisher suggested inflation would remain “meek” in the US amid a tepid recovery.
Suddenly the US government bond market is under the spotlight. For stock market investors of lesser experience, this relatively “new” cause for concern in the GFC is something which is not necessarily understood. However, those in Australia would be well aware that the federal government and opposition are currently engaged in a slanging match over the extent of government’s intended fiscal deficit and the time it will take to return to surplus.
What this simply means is the opposition is suggesting Australia is borrowing too much money, and just like any credit card holder with wide eyes and limited means, is kidding itself over just how long it might take to repay that loan.
America has the same problem, only on a scale that makes Australia’s deficit look like something out of the change jar. And America is the keeper of the world’s reserve currency. The US dollar is only as good as the strength of the US economy (and the US military, but we’ll ignore that for now), and as the GFC has proven, any business carrying too much debt is destined to get itself into trouble.
Average Joe would look at the extent of his borrowings in terms of what his annual income is, such that he might determine just how much is too much, or at least how long it would take to pay back his debts. For a government it means looking at net national debt in comparison to GDP, or that country’s annual “income”. Under the Obama Administration’s current budget plan, US federal debt was 41% of GDP at the end of 2008. Given the Administration’s various fiscal stimulus measures, the Congressional Budget Office projects US debt will increase to 82% of GDP in 10 years, assuming current policy measures are reined in along the way where possible. If there were no policy changes, debt could be 100% of GDP in five years, the CBO suggests.
That’s like Average Joe owing $50,000 when he only earns $50,000 a year but needs to pay it back as soon as possible.
America borrows money by issuing bonds of various maturities and those bonds provide an interest rate yield depending on just how much demand they attract. The more demand, the lower the yield. So devastating has been the GFC that the Fed has lowered its overnight cash rate to zero. This brings down yields on all maturities, and the 2-year bond is currently paying a yield of about 1%. Investors, terrified they will lose more money if they invest in stocks or commodities or other risk assets, have been quite happy to buy these bonds for only a 1% return. They are considered “safe”, in that investors have no doubt their money will be returned.
So strong was the demand for US bonds post the Lehman collapse that the US dollar rallied strongly, in defiance of the crumbling state of the US economy. That rally began to fade in recent months, however, and now the US dollar looks like it may take another dive. Of most concern is the amount of money the US government is “printing” in order to fund its various fiscal rescue packages, including the TARP and many other measures. That money needs to be borrowed from the world, via bond sales, or the US dollar will devalue due to oversupply.
If the US dollar devalues, the price of all dollar-denominated commodities will shoot up and suddenly inflation will once again be very real. Inflation erodes the value of investments. If inflation is 5%, a stock must rise by 5% in a year before the investor breaks even.
Neither a bank nor even a loan shark is prepared to keep lending money to Average Joe if he keeps coming back for more, and can’t offer much evidence of how he is going to pay any of it back. Yet the US government is now constantly asking the world for more and more money in order to stabilise its economy and, basically, to protect its way of life. Unfortunately the rest of the world needs Americans to enjoy a good life, because they are the world’s biggest spenders and consumers of goods. Everybody’s way of life is indirectly tied to America. But just how much more can the world lend?
Demand for US bonds can only wither when supply becomes overwhelming, and/or when the lender begins to question just whether the borrower can really pay it all back. To take that risk, the lender requires a higher rate of interest in return. That’s why the yield on a US 10-year bond has rapidly drifted out from 2.5% in March to 3.72% on Wednesday. There are too many bonds on issue. So many, in fact that in order to ensure a stable market the Fed has itself been forced to buy bonds. As the Fed gets its money from the Treasury, the Fed is buying bonds with printed money to pay for the money printed in the first place. Quantitative easing is really a bit of a Ponzi scheme.
The Fed is caught between a rock and a hard place. It has an obligation to support the reserve currency, and it has been forced to do so by stepping into the market to lead the buying of bonds. But the Fed also knows that every bond it buys is devaluing those bonds which are already on issue. Buy too few, and the yield could rush up further (sending the US dollar south). Buy too many, and the yield could rush up further because it’s just more printed money backing more printed money. The Fed has to get it just right.
To not get it right would be to subject the US to a sudden surge in inflation. The Fed is not concerned for now, because, as Fisher suggests above, inflation is expected to remain “meek”. He specifically suggested on Tuesday, “Given the vast amount of slack worldwide, the near term outlook for inflation is meek. Indeed, the recent pressures have been to the deflationary side.”
In other words, while workers are laid off and factories remain idle due to the GFC, inflation cannot be a problem. Factories are idle given there is little demand for products, and while there is little demand prices cannot rise, ergo no inflation. This, however, does not explain why oil was US$30 last year and is US$65 now despite record inventories and little more than a hope of economic stabilisation ahead.
Others might simply call that inflation.
It is the nature of inflation that if the market is expecting inflation, it will cause inflation. The oil market is currently driven by a belief that too much US debt will undermine the US dollar and lead to inflation down the track. Investors have thus bought oil ahead of what they see as an inevitable price rise, and in so doing caused that price rise, and thus inflation.
“I believe the risk posed by this debt is systematic and could do more damage to the economy than the recent financial crisis,” wrote John Taylor, Stanford professor of economics, in the London Financial Times this week. The deficit in 2019 is expected by the CBO to be US$1.2 trillion after collecting US$2 trillion in income. This means to balance the budget, a 60% across the board tax hike would be needed, Taylor notes. Obviously that’s not going to happen.
But one way to reduce debt is through inflation. Debt has a fixed face value, so while investments might erode through inflation, debt does the opposite – it declines in real terms. To bring the US deficit back from 82% of GDP in 2019 to 41% of GDP as it was in 2008 would require 100% inflation (the debt remains the same but GDP is doubled), meaning a 100% increase in prices. This equates to 10% per year for seven years, which, if it were to be the case, would make the “twenty-tens” look like the sixties and seventies.
Nothing would ever likely be that smooth nevertheless, Taylor suggests. We would more likely relive the 60-70s experience of boom followed by bust and recession every three to four years, and successively higher inflation after each recession.
Of course, if US inflation hit 100% over seven years the US dollar would halve over seven years. This is not what the Fed wishes to allow, yet the more the Fed buys government debt, the more likely that scenario becomes. The Fed must stand ready to reverse its support of US bonds very quickly. If the global economy does stabilise, the risk is that aforementioned economic “slack” could begin to be taken up and deflation halted. In order to avoid inflation, the Fed will have to raise its interest rate (pull money out of the system, sell bonds).
“Nobody I know on the (Fed’s policy) committee wants to maintain our current posture for any longer and to any greater degree than is minimally necessary to restore the efficacy of the credit markets and buttress economic recovery without inflationary consequences,” said Dallas Fed president Fisher on Tuesday. “Indeed, as I speak, we are studying ways to unwind our balance sheet in a timely way”.
Taylor’s response is, “That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably”.
But that’s just the Fed. The other problem is political. As Taylor notes, the Obama Administration’s line (and Australia will recognise it closer to home) is “We have an unprecedented financial crisis and we must run unprecedented deficits”. This is all well and good, notes Taylor, but the flipside is to run a balanced budget in good times. Obama’s budget means deficit for at least the next five to ten years, despite expectations of a return to normal economic growth over that period. “There is no economic theory or evidence,” says Taylor, “that shows that deficits in five or ten years will help to get us out of this recession”. The CBO expects a return to normal growth by 2014. “A responsible budget would lay out proposals for balancing the budget by then rather than aim for trillion-dollar deficits”, Taylor adds.
Obama has nevertheless declared, “We will cut this deficit in half”. In the meantime, CBO analysts predict the deficit will be the same in 2019 as it will be in 2010. Obama also points out he inherited a deficit, created by the previous administration despite years of economic boom. To that, Taylor says:
“The time for such excuses is over. They paint a picture of a government that is not working, one that creates risks rather than reduces them. Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged, and worsened the financial crisis. The problem is that policy is getting worse, not better. Top government officials, including the heads of the US Treasury, the Fed, the Federal Deposit Insurance Corp, and the Securities and Exchange Commission are calling for the creation of a powerful systemic risk regulator to reign in systemic risk in the private sector. But their government is now the most serious source of systemic risk.”
While the Republican opposition might have various questionable reasons as why they are against Obama’s policies, some within are arguing the policy is one of deliberately devaluing the US dollar in order to reduce the real deficit more quickly. If this is true, the Fed’s belief that economic recovery will be so slow as to preclude any inflation problem would be in jeopardy. The economy will still recover slowly, but inflation will rise due to oversupply of money. And then the economy would really struggle to recover at all.
