Widening deficits and
rising Treasury yields – the tide turns
US
Treasury bond prices topped out at the end of September,
and since then they have fallen sharply. The yield on
the 10-year bond has risen from 2.4% to 3.4%, which is
the break in the trend that those who believe bonds are
in a bubble were looking for. Much of this rise in
yields was after Congress agreed to extend the Bush tax
cuts, prompting rumours that US sovereign debt might be
downgraded by the rating agencies, given upward
revisions to the budget deficit.
The
extension of the Bush tax cuts could easily keep the
budget deficit above $1.5 trillion for the next two
years. To put this in context, Federal spending is to
remain at about $3.7 trillion and tax revenue at about
$2 trillion. This is not a reasonable credit
proposition for buyers of Treasuries and goes much of
the way to explaining the rise in yields. Because
Treasury yields are the principal determinant for all
dollar borrowing, everyone needing dollar-denominated
credit in 2011 should be very concerned that these rates
are rising.
Furthermore, there are the other bits of bad news coming
out of the US: a number of states are demonstrably
bankrupt, as are individual towns, cities and counties.
The whole public sector is one insolvent mess. Would you
really lend ten-year money to the government that
presides over all this for only 3.4%? The private sector
is in a fix as well. The banks have leant money with
increasing carelessness since the early 1990s and have
now lost more than their capital – though this has been
concealed from us as a matter of expediency. Private
individuals are unemployed, homeless or signed up for
food stamps, and those that are not – well, many of them
soon will be. It seems remarkable that any credible
economist or investment strategist has the gall to
forecast economic recovery in the foreseeable future.
It
is against this background that the Bush tax cuts have
been extended. Tax cuts are a good thing, but more
importantly than that there is still no attempt to deal
with excessive public sector spending. Politically,
spending cuts get more and more difficult the deeper
America sinks into its insolvent mire. The politicians
have had no option but to say that government deficits
will reduce when the economy recovers, giving them the
excuse for not cutting spending. That is why they
extended the Bush tax cuts. Together with the $600bn
QE2, the politicians see it as a one trillion-plus boost
to the economy. If only it were so simple.
Actually, QE2 is about the Fed printing money to buy new
Treasuries, because there are no other buyers at these
yield levels without the underwritten guarantee of the
Fed. It saves the politicians from addressing reality
because this new money can be found for Medicare, social
security, welfare handouts and defence, all of which
might otherwise be cut.
While finding it virtually impossible to restrict these
vital spending commitments, the politicians are also
unable to increase tax revenues. The political
imperative, to clobber the rich, will actually reduce
tax receipts below expectations, as the experience of
history has proved. And rescinding the Bush tax cuts
would have been counterproductive, by draining money
away from the productive private sector for the benefit
of the unproductive public sector. This must be obvious
to all but those blinded with Keynesian myopia, since
even the politicians seem to understand this point. But
they dare not take this chain of thought any further and
address actual spending. Rather, they leave it to those
clever guys at the Fed and their financial magic.
The
truth is that economic energy lost in public sector
bureaucracy and economic misdirection can only be made
up by borrowing from abroad or by printing money. If
overseas lenders are unwilling to lend, that leaves
monetary inflation, which will only work for so long as
the public does not understand what is happening to
money’s value. It is an attempt at economic
sustainability through monetary debasement.
Therein is the problem. In the coming months the wider
American public will become increasingly aware that all
this printing of money is just pushing up prices. QE1
was sold as a one-off emergency measure not to be
repeated, a response to the financial crisis and to stop
it becoming an economic one. Bond investors must now
suspect that QE2 is more about funding the deficit than
anything else. Indeed, the only reason Treasury yields
have been so conveniently low is the Fed has rigged the
market by buying Treasuries and mortgage bonds to keep
them there. Imagine the cost, and therefore the
increase in the budget deficit if long-dated Treasuries
were priced more correctly, perhaps at six to eight per
cent. It would become obvious to all that the US is
firmly snared in a debt trap, where higher interest
rates increase the deficit, requiring yet higher bond
rates to justify the extra default risk, and so on.
Hence the fear of the rating agencies’ credit revisions,
and that is what the market is beginning to understand.
Bernanke is an economist, not a market man, so there is
a possibility he is unaware the tide in the market has
actually turned. He may temporarily take comfort from
the increasing steepness of the yield curve, which makes
it profitable for banks to buy Treasuries financed by
short-term funds, bolstering their capital. But as the
money flows out of the dollar he will soon find the Fed
is alone as a long-term buyer of Treasuries. That would
cause serious damage to inflationary expectations.
Bernanke, the economist, will strongly resist raising
interest rates, perhaps denying the presence of
inflationary pressures much as he is today, or perhaps
blaming rising commodity prices on demand from the BRICS
rather than debasement of the dollar. The cost of such
obduracy will be a sharply lower dollar, adding further
to price inflation expectations and eventually forcing
interest rate rises on the Fed, who will always
reluctantly raise them too little too late.
The
timing and extent of this dollar weakness depends partly
on the Chinese. China’s own difficulty is also price
inflation, and the prime contributor is the yuan
currency peg. China will have no alternative, if she is
to control inflation, to raising her exchange rate.
Since China is now the principal source of demand for a
most commodities, a rising yuan will lead to yet higher
commodity prices in dollar terms.
It
is now becoming a case of when, rather than if, the
revaluation of the yuan happens. We can expect this to
be a major currency event, triggering yet more selling
by other foreign dollar holders. And to judge the
degree of dollar weakness, we must look at those raw
material and commodity prices, and not other paper
currencies, which have their own economic baggage to
contend with.
So
when the dollar plummets in the coming months, in
commodity terms at least, the inflationary pressures
will rack up, exposing the folly of Bernanke’s
theoretical economics of zero interest rates, QE1 and
QE2. The end of the Treasury bubble signals the end of
one interest rate era and the beginning of the next.
The highly indebted and those relying on further dollar
borrowing will be unfortunately crushed. The tide has
indeed turned.
28 December 2010
