Back in 2006, while working for a major US investment bank, I was asked by the Chief Global Economist to participate in a small survey to estimate the probability of the US economy facing a currency crisis—that is, one that forces interest rates higher—during the coming two years. Concerned that an eventual bursting of the US credit/housing bubble could lead to the dollar losing its pre-eminent reserve currency status, I placed the probability at some 60%, which was the highest response in the survey.
In 2007, he repeated the same survey. This time, I raised the probability to some 75%, as I believed there was clear evidence at that point that the credit/housing bubble was indeed bursting. Once again, this was the highest response in the survey.
Of course, the US has not yet faced a currency crisis and interest rates remain low. My past pessimism would seem, at first glance, to be unwarranted. But there was a period in late 2007 and early 2008 when the dollar came under severe pressure and serious talk began that the US dollar was indeed at risk of losing reserve currency status. Notwithstanding a period of relative dollar strength over the past two years, such talk continues to this day. Given where we are now, were I asked yet again to place a probability on a dollar crisis occurring during the coming two years, I would place it at 80-85%.
Why so high? Because the US economy is now entering a period of even greater economic danger than in 2007-08 and also because all major economic policy decisions taken by the US fiscal and monetary authorities since 2007 have fundamentally undermined the dollar’s reserve currency status. That said, the fiscal and monetary authorities of numerous governments have also made decisions undermining their respective currencies. It is increasingly probable that not only the dollar but various other currencies are going to face crises during the coming years, ending quite possibly in a general devaluation of fiat currencies vis-à-vis real assets. The rising price of gold may indicate that others share this view.
The Real Economic Horror Show
To many observers it is increasingly clear that the US economy is now heading into a dreaded “double-dip”. But it should come as no surprise that, as the various forms of fiscal and monetary stimulus implemented in 2008-09 fade, economic activity is weakening again. After all, the recovery never showed signs of being self-sustaining in the first place, as business investment and job creation remained relatively anaemic when compared to previous post-recession periods.
For those espousing stimulus-based neo-Keynesian policies, this situation presents a sort of economic double-horror-show: First, it appears that the stimulus, although unprecedented in scale and scope, has not worked. Second, the US and many other countries now find themselves saddled with significantly larger debt burdens than before, which threatens to constrain government borrowing in future. If that happens, then you can kiss any further hope of additional government stimulus goodbye. Several countries have already been forced by financial markets into accepting that they have exceeded their practical borrowing limits. There is little doubt in our minds that, as the double-dip intensifies and spreads around the globe, additional countries are going to join this undesirable club.
For those like us who do not believe in neo-Keynesian, “free-lunch economics”, the spread of sovereign debt crises is neither unexpected nor unwelcome. Indeed, the financial markets are doing exactly what they are supposed to be doing, which is to place growing constraints on wasteful economic activities, namely government policies that misallocate resources from productive and sustainable to unproductive and unsustainable activities. Sovereign debt crises are part of the solution to unsustainable policies. The other part, of course, is to bring about an end to such policies. We are not there yet, not by a long shot, but in a few places such as Germany, the UK, Greece and Ireland, the trend has shifted in this direction.
Curiously, given its free-market traditions, the US is not only not joining this change of trend, it is accelerating the growth of government. It is not just that the government has taken over significant parts of various industries such as healthcare, consumer finance and automobiles. Government job growth in general is outstripping the private-sector at an historic pace. And given the severe weakness of the private-sector, government wage growth is also growing rapidly relative to the private sector.
Steady government jobs growth has outstripped private for a decade
Of course to finance this require some combination of a large increase in tax revenues and government borrowing. But with the private sector not growing, increasing tax revenues is going to be difficult if not impossible. This leaves increased borrowing as the only option.
It is therefore obvious to us that US government borrowing is going to soar as the economy sinks into the double-dip. Rather than declining in 2011-12, the government is likely to run even higher deficits. But what if the government decides, in response to the weakening economy, to enact another round of stimulus? The deficits will be commensurately higher. What if the federal government begins to bail-out state governments facing funding crises, either explicitly or through less overt subsidies? The deficits will be commensurately higher. Given the current political climate and rhetoric coming out of Washington, what is the probability that, in response to the double-dip, the government enacts additional stimulus and bails out a handful of state governments? We consider it to be quite high.
To us, this is the real economic horror-show. Not only is the most unproductive part of the economy—the federal government—growing dramatically relative to the most productive—the private sector—but the implied future debt burden is also rising dramatically. In other words, the effective tax base is shrinking alongside an exploding public debt burden! The US is therefore already falling into a debt trap from which there is no escape without a dramatic shrinking in the size of government. But what are the odds that Washington is going to decide to shrink itself voluntarily absent a debt crisis? We believe they are remote, which implies that this situation is not going to be resolved without financial markets forcing the issue.
The New Conundrum of Low Treasury Yields
Are we alone in thinking that a US debt crisis is all but inevitable? If not, why aren’t Treasury bond yields heading higher if the deficit is about to explode on the upside and the US is destined to face a debt crisis in the coming years? The answer to this apparent conundrum is surprisingly straightforward: supply and demand. Yes, Treasury supply is going up, but so is demand. But why is demand going up as a debt crisis becomes more and more inevitable?
Let’s take a look at who buys Treasury securities, and why. Much of the Treasury market is held by government and financial institutions that, in practice, have little discretion. To the extent that there is a free-market in Treasury securities, it exists amidst much official, somewhat systematic buying from the Fed, foreign central banks, US state and local governments and US financial institutions.
The Fed buys Treasury securities as a matter of policy as this is how it normally goes about expanding the monetary base. As such, Federal Reserve Treasury holdings are not a form of discretionary investment but rather a requirement of policy. At end Q1 2010, Fed Treasury holdings stood at 7bn.
Foreign central bank holdings are also a matter of government policy in that they grow with balance sheets. These have risen dramatically in recent years and at end Q1 stood at about .1tn.
Foreign central banks continue to accumulate Treasuries at a steady pace
State and local government holdings of Treasury securities are also quite substantial, at 5bn as of end Q1 2010. These are not for pension funds or other investments but rather for liquidity management. As such, they are also not discretionary holdings and they tend to grow rather steadily with state and local government budgets over time.
US commercial bank lending has been declining since H2 2008...
US commercial banks are also large holders of Treasuries, about .5tn at end Q1. Now under normal circumstances in which the financial system was not in distress and bank lending was growing at a healthy pace, these holdings could rightly be considered discretionary as they would reflect to some extent the bank’s trading view on the direction of yields. However, commercial bank lending has declined sharply over the past year. If banks are unwilling to lend, presumably because they can’t locate enough suitable, creditworthy borrowers, then an obvious, low risk alternative to making loans to the private sector is to make loans to the Federal government in the form of Treasury purchases. Yields may be low, but at 2-3% they are well above the mere 0.25% banks receive for keeping excess reserves at the Fed.
...but banks ARE lending, if only to the government!
Federal Reserve data: Treasury securities outstanding
Adding up the Treasury holdings of these various groups we arrive at a total of around .5tn, or some 2/3 of all marketable Treasury debt, which we can assume is not held for primarily discretionary, investment-driven reasons.
Now a Treasury market analyst might argue that it is not the amounts outstanding, but rather the flow of new paper into the market, which is likely to influence the price and hence the level of yields. As such, it is instructive to look at the flows data, to see which entities have been the most important marginal buyers of Treasuries recently.
In Q1 2010, the Treasury issued roughly .45tn of securities at a seasonally-adjusted annual rate (saar, as are the following figures). Of this amount, bn was bought by the Fed and roughly 0bn was bought by foreign central banks. State and local governments were net sellers in the amount of bn, which is not surprising given that their fiscal position is deteriorating. Federal agencies were big purchasers during the quarter, buying 3bn, by far the largest amount on record. Commercial banks bought 6bn. As discussed above, absent commercial credit growth, this most likely reflects a general attempt to generate some income from the huge amount of excess reserves sitting on bank balance sheets. Adding this up, these largely non-discretionary buyers took down some 1/3 of all issuance in the quarter.
Federal Reserve data: New Treasury security purchases by sector
Given the large presence of non-discretionary buyers in the market, it is questionable whether or not the observed yield curve at present is close to where a purely discretionary market would place it. There is also the issue to consider whether, given this market structure, investors are discouraged from shorting the market even if they anticipate higher yields in future.
This is why the growing debate around the possibility of another round of quantitative easing (QE) is of key importance for investors. QE is nothing more than a policy-wonk term for the monetisation of debt, although policymakers might argue, against historical experience, that it is merely a temporary measure. In a risk-averse environment, some investors might prefer the risk of losses in Treasury securities at some point in future to the risk of near-term losses in equities or other risky securities and hence overweight the former relative to the latter.
However, those investors shorting Treasuries with a longer-term view that yields are headed higher someday as a debt/currency crisis eventually arrives must assume the risk in the meantime that the monetary authority chooses to monetise some portion of the debt, thereby preventing a rise in yields. In this case, those who are short are going to sustain losses in the domestic currency. And unless the domestic currency weakens, those short are going to sustain losses in terms of other currencies as well. It is only in the event that the currency devalues that investors going short will profit. Such perceptions of risk, influenced as they are by credible threats from the monetary authority, most certainly contribute to the conundrum of low yields in the face of rising risks of a debt/currency crisis in future.
Absent a sustainable US economic recovery, in which demand for capital from the private sector would compete with the public sector, thereby driving up Treasury yields, a US debt crisis is highly unlikely to occur absent a currency crisis. But for the issuer of the pre-eminent global reserve currency, the two are really just different sides of the same coin. The dollar comprises a huge portion of the world’s monetary base and hence a huge portion of day-to-day transactions are made in dollars. As the world’s pre-eminent financing currency, a huge portion of day-to-day borrowing and lending also takes place in dollars. Not until the global investor base is ready to replace the dollar with something else is the dollar truly vulnerable to a crisis of sufficient magnitude to push Treasury yields up to levels which would in effect force the US government to downsize, default, or both.
How far are we from this point? We don’t know. We would argue that nobody knows. But we are much closer now than we were in 2008, back when many people actually had confidence that swift action in the form of fiscal and monetary stimulus would work to put the US economy back on a sustainable path. That confidence is already beginning to fade. As the US deficit climbs and climbs and yet the economy remains weak amidst growth in government at private-sector expense, confidence will fade far more. We believe that the US will face a general debt and currency crisis before the end of 2012.
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Given that the structure of the Treasury market is such that existing yields may not offer investors fair-market compensation for the risk of a US debt/currency crisis in future, and that the same might be said of numerous other countries’ government debt markets, how should investors prepare for another round of QE in the US and/or elsewhere?
One option would be to purchase Treasuries or other government securities in anticipation of a QE-induced rally. Indeed, the recent rally in Treasuries and certain other major government bond markets could be in part a result of QE anticipation. However, because it is impossible to know at what point or in what magnitude a currency might begin to weaken as a result of the money printing associated with QE or the sudden arrival of a general sovereign debt/currency crisis, we would consider purchasing government bonds to be a form of speculation rather than investment. At the same time, however, being short would appear dangerous heading into another round of QE. At this point in time, rather than speculate, we would be on the sidelines of the government bond markets.
If the very reason why QE is becoming more likely is because we are headed into a double dip, then it is probably not a good time to be overweight risky assets in general, such as corporate equities or bonds. Leading indicators may indicate that the cyclical outlook is deteriorating but of perhaps even greater concern is that structural factors, in particular the growth of government relative to the private sector and of increased regulation, are going to constrain after-tax personal incomes and corporate profit growth in the coming years. Defensive equities with high dividend yields would, however, provide some diversification in broader portfolio of assets.
For many investors, this overall picture would imply a retreat into cash. But if we are right that the US and most probably certain other governments are rapidly heading toward a general debt/currency crisis, cash is also not the best place to be. There are likely to be brief periods of cash outperformance as investors flee out of risky assets. But if policymakers stand by, ready to implement another round of QE each and every time it appears that risk aversion is rising to unwelcome levels, such periods of cash outperformance are bound to be fleeting. Basic investment logic dictates that you don’t want to be overweight that which is rising rapidly in supply, at times suddenly and unpredictably.
Those risk-averse investors inclined toward cash should therefore diversify into liquid, primarily defensive commodities. Defensive commodities are those with only a weak correlation to risky assets. Unlike government debt, these do not carry default or devaluation risk. Yes, they can decline in value, but as a group this is highly unlikely unless there is a general flight to cash which, as discussed above, is likely to be met swiftly with yet another round of QE. There is nothing wrong in principle with trying to trade the market, getting long commodities only following a period of cash outperformance and when QE appears imminent. But for most investors, a buy and hold strategy is probably more appropriate. When the smoke clears following each successive round of QE, a broadly-diversified basket of liquid commodities is likely to have outperformed a traditional portfolio of government bonds and corporate securities, as has been the case on average over the past decade. Absent meaningful structural reform, this trend could continue indefinitely.
The Amphora Liquid Value Index
Source: Bloomberg LP
