Who will finance America's deficit?
By David P Goldman
The United States government needs to borrow US$1 trillion a year, before a new
stimulus package, or handouts for the auto industry, or healthcare reform, or a
dozen other spending programs promised by the incoming administration of
president-elect Barack Obama. Where will the Treasury find the money?
A bizarre jump in the US Treasury's real cost of borrowing points to severe
market disruption if the Treasury deficit continues to rise. It appears that
the Treasury market is also a victim of global de-leveraging. The new
administration has far less budgetary flexibility that it seems to think. In
1981, under comparable
circumstances, Ronald Reagan had far greater room to maneuver. I conclude that
the new administration is virtually powerless to prevent marked deterioration
of the US economy.
A comparison of Obamanonomics and Reaganomics is instructive. Even in the
unlikely event that the Obama administration were to adopt Reagan-style
incentives to risk-taking and investment, the effect of such incentives would
be weaker and slower to take effect than in 1981-1984.
As shown in Exhibit 1, the yield of the 10-year inflation-indexed Treasury
(TIPS) tripled from 1% to 3% between June and October 2008. Nominal Treasury
yields fell slightly, because the inflation-expectations component of Treasury
yields (the difference between ordinary 10-year Treasury notes and
inflation-indexed TIPS) collapsed, from 250 basis points to less than 100 basis
points.
The jump in TIPS yields should ring alarm bells. It is not only that
inflation-indexed Treasury yields never have risen so fast and so far since
their introduction in 1997. What is most bizarre is that the movement in "real"
Treasury yields is not only massive, but in the wrong direction. Both economic
theory and all past experience tell us that when economic activity falls,
"real" yields also should fall.
Exhibit 2 below shows that 10-year TIPS, or "real" Treasury yields have moved
in the same direction as equity market returns. The inflation-adjusted Treasury
bond yield is a rough proxy for real long-term interest rates (it is only a
proxy because the consumer price index - or CPI - is not necessarily a good
measure of inflation). Real rates are supposed to reflect growth expectations;
higher growth means higher returns to financial assets, including bonds. TIPS
yields are plotted against 12-month returns to the S&P 500. The two lines
move together except during the past few weeks, when they take sharply opposed
directions.
Exhibit 2: TIPS yields triple while S&P 500 crashes.
How weird the behavior of TIPS yields has been during the past few months is
made even clearer by Exhibit 3, below. We observe that TIPS yields and S&P
500 returns lined up neatly between 2004 and 2008, and suddenly moved in the
opposite direction.
Exhibit 3: Scatter plot of TIPS Yields vs 12-month S&P 500 returns,
January 2004 through October 2008.
Just when we should have expected "real" Treasury yields to collapse along with
equity market returns, they spiked upwards, and by the largest margin on
record. Evidently something has changed, and changed drastically. One component
of Treasury yields, expected inflation, has collapsed, and the "real" component
has jumped.
There is no question as to why the expected-inflation component has fallen, for
it has done so along with the S&P 500 and the main commodity price index
(the Constant Maturity Commodities Index published by UBS and Bloomberg). This
relationship is shown in Exhibit 4 below.
Exhibit 4: 10-year breakeven inflation, Constant Maturity Commodity Price
Index and S&P 500, February 1, 2008 to November 6, 2008 (normalized).
Equity, commodity and Treasury bond markets all are registering a deflationary
crash in precisely the same way. That seems clear enough. The dog that barked,
but shouldn't have, is the "real" component of Treasury yields.
The answer to the mystery of tripled real Treasury yields is to be found in the
collapse of leverage in the global financial system. Indirectly, the rapid
expansion of leverage in the global banking system contributed to demand for
Treasuries. When de-leveraging commenced in August, an important component of
demand for Treasuries declined sharply. That is bad news for Washington, but
even worse news is that it will continue to decline sharply, just when
Washington most requires global support for the US government debt market.
Global leverage indirectly increased demand for Treasuries in three principal
ways:
1. It fed the boom in raw materials prices, increasing demand for Treasuries on
the part of central banks as well as financial institutions in
commodity-producing countries.
2. It pushed up the value of emerging market currencies, prompting emerging
market central banks to intervene in foreign exchange markets by purchasing
dollars which then were invested in Treasuries.
3. It contributed to the rise in global equity prices, which prompted investors
to diversify their portfolios and purchase safer assets including Treasuries.
The carry trade, in which investors borrow low-interest currencies (dollars or
yen) and buy high-interest emerging market currencies, created demand for
Treasuries by funneling money into emerging markets that ended up as dollar
reserves in their central banks.
Exhibit 5: Net foreign purchases of US Treasury securities,
12-month rolling total.
At the peak of demand for US government securities, net foreign purchases of
Treasuries came to $400 billion per year, according to the Treasury's TIC data
base (Exhibit 5). Who were the buyers? The Treasury data offers some answers.
Exhibit 6: Foreign holdings of US Treasury securities as
of August 2008 (US$ billions): total holdings, year-on-year
%change, and year-on-year absolute change.
We observe that the biggest increase came from offshore banking centers (the
UK, Switzerland, Luxembourg, and Caribbean banking centers). This tells us
little because anyone may transact through such centers. "Other emerging
markets", notably Brazil and other commodity producers, were the second-largest
contributor, followed by Japan and the oil exporters.
Private purchases of Treasuries are larger than official flows in recent years,
as shown in Exhibit 7:
Exhibit 7: Private vs official net purchases of US Treasury securities.
As noted, private purchases of US Treasuries seem to scale to global wealth. We
observe a fairly close relationship between global equity market capitalization
(as measured by the MSCI World Index) and private purchases of US Treasuries,
as in Exhibit 8.
Exhibit 8: Private net purchases of US Treasuries scale to MSCI World
Index, 1988-2008.
An exception occurred during the peak of the US equity boom of the late 1990s,
when Treasury purchases fell off at the peak of the boom. Evidently this
exception reflected the general euphoria of the time and investor preference
for riskier assets. We do not have Treasury data past August, and it well may
be the case that a similar exception will emerge during the second half of
2008, as foreign investors increase their net purchases of Treasuries while
stock markets crash, and for a symmetrically opposite reason. Investors may
prefer safer assets.
We cannot directly estimate the impact of de-leveraging on the Treasury market,
but it seems clear that the explosion of leverage during the past five years
had a profound, if temporary, impact on the world market's demand for US
government securities. As a rough gauge of the growth of global leverage, we
observe that between 2003 and 2008, US banks' claims on foreigners nearly
tripled from $1.2 trillion to $3 trillion.
Exhibit 9: American banks' claims on foreigners.
We can observe in the movement of market prices, though, a close relationship
between the breakdown of the carry trade and the rise in real Treasury yields.
Withdrawal of leverage from the system forced market participants to liquidate
carry trade positions, that is, to unwind short positions in Japanese yen, and
to liquidate long positions in carry trade currencies such as the Brazilian
real, Turkish lira, South African rand, Australian dollar and so forth. I use
the parity of the Brazilian real to Japanese yen as a rough proxy of demand for
carry trade. As Exhibit 10 below makes clear, the collapse of the carry trade
(the fall of the Brazilian real against the yen) closely tracks the rise in
10-year TIPS yields. The visual relationship is confirmed by econometric
analysis.
Exhibit 10: Inflation-indexed (TIPS) Treasury yield vs Brazilian real/yen
parity.
The Treasury market benefited from the explosion of bank leverage during the
past 10 years, as emerging market central banks became the most important new
buyers of US government securities. De-leveraging and the collapse of commodity
markets combine to destroy global demand for Treasuries, limiting the US
government's capacity to borrow from overseas sources.
Other major holders of US Treasury securities are likely to wish to reduce
their holdings rather than to increase them. China's accumulation of foreign
reserves represented "rainy day" savings for the nation, and the severity of
the present crisis shows how well-advised China was to accumulate a large
volume of reserves. China has announced plans to spend the equivalent of 20% of
gross domestic product in a stimulus program which is likely to increase the
country's demand for foreign capital goods.
China's trade surplus is likely to diminish sharply, both due to falling export
demand and import growth arising from the stimulus package. Chinese reserves
are likely to cease growing and may even decline as a result. Oil-producing
countries, moreover, may have to spend reserves in order to maintain import
levels as a result of the collapse of oil prices.
Foreign net purchases of US Treasury securities peaked at a $400 billion annual
rate, and will fall sharply from this level. Domestic resources to purchase
Treasury securities, moreover, are thin. When Ronald Reagan took office,
America's personal savings rate was 10%; today it is around 0%, although it has
spiked up in recent months. Disposable income in the US now stands at slightly
under $11 trillion. If the US returned to the personal saving rate of 1981,
individuals would save $1 trillion a year, enough to fund the Treasury deficit,
assuming that all net new portfolio investment flowed into Treasury securities.
Nothing, though, would be left over for investment in anything else.
One way to gauge how onerous the Treasury's borrowing requirements appear
compared with available savings is to take the ratio of government borrowing to
gross private savings, as in Exhibit 11 below.
Exhibit 11: Federal budget deficit as a % of gross private savings.
We observe that in 1981, the deficit stood at around 15% of gross private
savings, and reached 30% at the worst. The deficit already has reached 50% of
gross private savings, before the new administration has had the opportunity to
increase spending.
In 1981, moreover, the United States was in current account surplus, and
foreign purchases of Treasury securities were a very small factor in the
financing of the government deficit. Today, the current account deficit (and
the corresponding capital account surplus) is almost 6% of GDP.
It is far from clear from whom, and on what terms, the US Treasury will obtain
$1 trillion a year, or even more, to finance its deficit. The overseas well has
run dry, and domestic financing of the deficit would require a drastic increase
in the savings rate at the expense of spending, or outright monetization of the
debt by the Federal Reserve.
One way to increase the government savings rate, of course, is to increase
taxes, but that is an unlikely course of action during a severe recession.
Monetization of debt remains a possibility, and to some extent would only
continue the current trend. Total Federal Reserve Bank credit outstanding has
more than doubled in the year to November 6, 2008, rising by $1.2 trillion to
$2.06 trillion. This reflects loans, securities purchases, and related actions
by the Fed to bail out the financial system. If the deflation persists, the
Federal Reserve may be compelled to purchase US government debt.
Another possibility is that risk appetite among investors at home and abroad
will continue to fall, inducing a portfolio shift towards Treasury securities.
In this case "crowding out" will occur through risk-preference. It will not be
so much that competing borrowers are crowded out of the lending market, but
that investors will stampede away from risk. In this scenario, even a very low
federal funds rate will not help to restore economic activity.
The point of lowering the risk-free rate is to push investors towards riskier
assets. In a normal business cycle, falling output leads to lower yields on
low-risk bonds, which in turn encourages investors to add risk to their
portfolios by investing in businesses. If the safest of all investments, namely
US Treasuries, suddenly offer much higher real yields, comparable to the boom
years of the late 1990s, why should investors take risk?
In any of these scenarios, the result of global de-leveraging is dire: the more
the US government tries to bail out businesses and households, the more bailing
out the economy will need. The Bush administration's response to the financial
crisis, and the likely content of the Obama administration's economic program,
will deepen and prolong the economic downturn.
It is not generally remembered that the premise of the Reagan administration's
tax cuts was Robert Mundell's work on the optimal level of government debt.
Mundell, who won the Nobel Prize in 1991 for his work on international
economics, observed that an increase in government debt might represent an
improvement in market efficiency, if it corresponded to an increase in incomes.
That might occur if a reduction in taxes caused an increase in the deficit,
while stimulating economic growth. In that case, Mundell argued, a tax cut
would increase efficiency if the additional revenues arising from the growth
effect were larger than the interest on the bonds issued to cover the ensuing
deficit.
In 1981, Ronald Reagan had a very different starting point:
1. The personal savings rate stood at 10%.
2. The current account was in surplus.
3. The top marginal tax rate was 70%.
The capacity of the US and the world to finance an increase in the federal
deficit was much greater, and the incentives arising from reducing the top
marginal tax rate from 70% to 40% were much greater than any incentives that
might be envisioned from tax cuts from the present level.
Even the best-designed economic policy would be hard-put to provide growth
incentives without a substantial increase in the savings rate and a
corresponding reduction of consumption, implying a very sharp economic
contraction. If the Treasury tries to spend its way out of recession, the
results are likely to be very disappointing.
David P Goldman was global head of fixed-income research for Banc of
America Securities and global head of credit strategy at Credit Suisse.
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