The price of 10-year Treasury Notes dropped more last week than any week since June 2008; the rate rose above 3.4% for the first time since last November. The dollar tumbled below 1.4000 to the euro for the first time this year. Its 3.6% loss for the week was the largest decline against the euro after it sank 4.8% in the five days to March 20th. And the Dow declined four days out of five, rising over 200 points on Monday but finishing the week flat.
All three markets were reacting to the same stimulus: the enormous amount of debt, $3.25 trillion that the United States Government has to sell by the end of its fiscal year on September 30th to fund its operating deficit, various financial rescues, and economic stimulus payments.
For the bond market the vast supply of current and pending issuances threatens to overwhelm demand. It is not that the government will not be able to sell debt and fund the deficit, it will, the question is at what cost. Higher rates for Treasuries will add substantially to the government’s funding costs further increasing the deficit. They may also boost mortgage and consumer interest rates, just as the Federal Reserve is attempting to keep rates low to foster consumer spending and economic growth.
The dilemma for the Fed and Ben Bernanke is keen. On March 18th the Fed announced that it would buy $300 billion of US debt over the next six months. Since then ten year bond yields have increased 92 basis points to 3.45% and the dollar index, which tracks the US currency against a basket of euro, yen, pound, Swiss franc, Canadian dollar and Swedish krona, has lost 11% since its March 4th high. The last FOMC minutes contained comments from some Fed officials which indicated that even more asset purchases may be necessary to secure an economic recovery.
But in the current economic environment, and especially in light of the government’s unprecedented funding needs, extensive Fed purchase of government notes, commonly called ‘quantitative easing’ might cause as much harm as good. 'Quantitative easing' or monetization of government debt increases the money supply and stokes fears of future inflation. It also contributes directly to present inflation by undermining the dollar and increasing the cost of dollar priced commodities like crude oil which feeds back into consumer price inflation. Last summer’s $4.00 a gallon gasoline was at least partly caused by a historically weak dollar. Oil prices and the dollar began their inverse moves within days of each other in July and oil prices have again gained in the past few weeks even though there has been little change or prospect for a rise in demand. A depreciating dollar also makes US securities that much less attractive for foreign investors who are the major buyers of US Government debt.
In a normal economic situation the anticipation of higher US rates would support the dollar. But these are not normal times. At this point in a standard recession, with three quarters of negative growth already passed, historically low rates and massive amounts of added liquidity, thoughts would naturally turn to the beginning of the next Fed rate hike cycle. The dollar would follow these thoughts higher.
But Fed rate policy is constrained by the unabated recession, by the residue of the financial and banking crisis, and by the fear of a deflationary price spiral. The Fed cannot raise rates. With its ability to fight inflation near zero for the immediate future, the prospect of higher Treasury rates only means more Fed quantitative easing to keep consumer and mortgage rates low and an ever increasing danger of inflation.
Compounding or highlighting the US debt problem was the rating agency Standard & Poor’s (S&P) downgrade for the outlook of United Kingdom sovereign debt to negative from neutral. S&P said the UK faces a 1 in 3 chance of a rating cut as its total debt approaches 100 % of GDP.
If the UK is at risk, what of the US with its massive funding needs? The risks to the world’s economic and financial system which in the past nine months have worked strongly in favor of the US currency as the safe haven trade have been replaced by risks specifically to the dollar from the US debt and deficit burden.
US debt is currently about 80% of GDP. "Both the UK and the US have deficits of 10% annually as far as the eye can see" said Bill Gross co-chief investment officer of Pacific Investment Management Company (Pimco) of Newport Beach California in an interview with Bloomberg Television. “At some point over the next several years they (the US) may approach 100% of GDP which is a level at which country downgrades tend to occur.” “The markets are beginning to anticipate the possibility of” a downgrade to the US’s top rating though, “it’s certainly nothing that is going to happen overnight”, he said., “eventually” the US will lose its top rating.
Higher rates for US Treasuries if they indicate an oversupply of dollar assets are dangerous for the dollar’s status as the world’s reserve currency. One of the basic functions of a reserve currency is as a store of value for liquid assets. If investors look into the future and see only an ever increasing supply of inflationary dollars in numbers far beyond the rate of economic growth in the US, issued by Washington to fund its deficits, then suspicions that the US is attempting to inflate away its mountain of debt will gain credence.
The current administration isn’t just issuing record debt this year or next but projects record deficits for the next ten years. The government’s position is that this scale of debt is necessary to help the US avoid the worst effect of the recession. But the political nature of much of the stimulus spending has been roundly condemned by administration critics. If the concerns of critics are accurate and the budget emphasis is misplaced, and the stimulus does not produce substantial economic recovery by the end of the year, then the debt and the deficits will weigh heavily on the future of the dollar.
If the credit markets can absorb the US issuance over the next three months without driving up interest rates and the US economy begins to show signs of positive growth by the beginning of the fourth quarter then the stage is set for a return of the dollar to strength. But if Treasury rates continue to rise and the Fed is forced into extensive quantitative easing to contain them then market judgment against the dollar could be harsh indeed.
Joseph Trevisani
FX Solutions, LLC
Chief Market Analyst
FX Solutions
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