Alasdair Macleod – 28 December 2010
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.