By RGE Monitor
Bank rescue via TARP funds, the bailout of the GSEs and two fiscal stimulus packages have put severe pressure on the US fiscal deficit since 2008. Despite having little bang for the buck in the short-term, the recently passed $787 bn fiscal stimulus package will have a bill of $185 bn in FY2009 and $399 bn in FY2010 (based on Congressional Budget Office estimates), adding to the US governments financing needs.
Given further downside risks to growth and bank losses, another stimulus package and more funds for bank recapitalization will be required during 2009-10.
After a deficit of $455 bn in FY2008, these expenditures will push the US fiscal deficit to $1.6-1.8 trillion in FY2009 (already $569 bn in Oct 2008-Jan 2009) and over a trillion in FY2010. This along with plunging individual, corporate and investment related tax revenues imply the country’s target to balance the budget by 2012 might not be achieved. The Congress has already raised the ceiling for national debt to $12 trillion while the govt debt/GDP ratio is expected to exceed 85% in FY 2009.
The financing needs of the US government will thus be very high in 2009 and 2010, leading many to question how these needs will be met, particularly as the reduction in commodity prices and capital inflows to emerging markets has slowed central bank reserve accumulation. Treasury yields have already been rising from their November 2008 lows on concerns of increased supply. Suspicions that the interventions will raise Treasury debt issuance could exacerbate the sell-off in longer-dated Treasuries – the benchmark 10-year note broke above 3% on February 9 for the first time since November 2008.
There are several stumbling blocks ahead for treasuries. Despite some recent climbs, yields are still near record lows, leaving little scope for further capital gains from price appreciation. The low or negative carry of US treasuries over sovereign debt elsewhere plus the long-term downtrend in the dollar erodes the relative appeal and total return of treasuries to their foreign holders.
Meanwhile US retail investor purchases of savings bonds have been declining for the past 20 years.
Foreign central bank purchases of US debt to build up FX reserves may wane as export receipts fall on a contraction of global trade. Foreign treasuries are turning their spending inwards to stimulate their own slumping economies which may reduce their purchases of US assets. Middle Eastern oil exporters, for example, are absorbing most if not all of their now much lower oil revenues at home. Saudi Arabia’s foreign assets fell in December in what could be the start of a trend.
Crowding in the world market for government debt could intensify the competition for buyers. While Treasury issuance will reach unprecedented levels this year, other governments around the world are in similar predicaments and will pay higher yields to absorb their debt supply increases.
Although the scale of increase in treasury issuance is quite extensive, there is reason to believe that demand will hold up. Risk aversion, debt monetization, deflation, deleveraging, and USD funding shortages abroad as corporates seek to refinance their debt may cap the rise in treasury yields. Uncertainty over the effectiveness of the government’s interventions may keep risk appetite fragile and the preference for liquid assets high as corporations, especially in the emerging world, seek to refinance their debt and governments provide capital to the banks.
The lack of a quick fix to the financial crisis adds support to treasuries as investors may continue to shift from risky assets to fixed income especially Treasuries even if the flight to the shortest-term assets may wane.
Like the Treasury, the Federal Reserve is considering using old tools to solve current problems. At the last FOMC meeting on January 28, the Fed announced it was prepared to buy longer-term treasuries to keep long-term market interest rates low. Debt monetization may fail to keep treasury yields low though, if markets believe quantitative easing will fail.
Strong deflationary headwinds (such as anemic credit growth) could pare the premature climb in inflation expectations seen so far this year.
Finally, as the US savings rate increases back to its decade ago average of 6%, Americans may start plowing any money left over from debt repayment into savings bonds.
Risky assets had rallied recently but the continued deterioration in economic fundamentals around the world suggests the dollar will once again enjoy its safe haven status once investors flee back to Treasuries. Deleveraging of cross-border USD-denominated liabilities is still providing juice for the dollar against G10 currencies (except the yen and swiss franc), though with less vigor than in Q4 2008. Against the euro, the US dollar will likely strengthen a little further in the near-term on expected ECB rate cuts, intensifying Eastern European financial turmoil and eurozone sovereign credit downgrades. Later on though, rate differentials may tip the overvalued dollar into a correction if ECB easing looks likely to trough at a higher level than the Fed.
Against the yen, the US dollar will likely gain briefly in the near-term as markets focus on Japan’s deteriorating economic fundamentals before speculation over end-March yen repatriation and waxing risk aversion reclaim the dollar.
In general, the dollar will benefit in the short-term from US government interventions if they appear to put the US ahead of the curve in fighting the recession compared to Europe and Japan.
In the near term, the need for liquid assets, the lack of global alternatives (the European bond market is fragmented and under stress from macroeconomic divergences) and the depth of liquid assets in the US may keep attracting capital from both foreign and US investors.
GCC countries, which aside from Saudi Arabia were once the most risk tolerant of sovereign investors, are now seeking out more liquid assets to meet spending and financing needs.
Furthermore, with the global economic outlook being weak and trade contracting, countries like China may keep intervening to keep their currencies weaker in the hope of export competitiveness, keeping them buying US assets. The recent uptick in risk appetite in China and somewhat optimistic economic indicators may increase inflows into China even if hopes of an economic turnaround seem as yet, premature. China and Japan, the largest holders of US debt, are wary of a collapse in dollar assets which would reduce their past holdings – avoiding such an outcome might keep purchases on stream, if at a more subdued pace.
Furthermore other assets, including perhaps corporate bonds could also benefit from inflows as they did in December 2008, In short, it seems the US dollar still has some tricks left up its sleeve before it capitulates to a long-term downtrend.
Treasuries and the US dollar are not the only instruments benefiting from risk aversion. Gold could be considered an even safer ’safe haven’ if it weren’t for its susceptibility to speculative excess. But that didn’t stop strong demand for a safe haven and a store of value from pushing gold up to the $950/oz level on Comex as of February 12, 2009 – 25% above its fair value assayed by physical supply and demand. Uncertainty over the global economic outlook continues to send investors running for cover in cash-like instruments.
But as sovereign credit risk rises around the world due to sharp increases of public debt, some investors are scurrying towards apolitical cash-like instruments. Gold fits the bill as it is not tied to any particular country’s asset quality. In addition, rising inflation expectations (in the longer-term) have spurred demand for gold as investors worry massive government spending and possibly debt monetization will be inflationary, which would have deleterious effects on currencies as a store of value.
Despite likely pullbacks in the gold price this week as incoming data signals deflation, analysts believe gold will reach $1000/oz within 3 months due to ongoing uncertainty over the outlook for the global economy, inflation, sovereign debt and currencies. Yet if there is a reduction of risk relating to sovereign defaults, gold could soften in the mid-term especially if central banks keep inflationary pressures under control once the economic recovery begins and the velocity of money picks up.
Source: RGE Monitor, February 17, 2009.
