Dollars, Deficits and "Duh" in Davos
New York | With the global punditry assembled in Davos this week, the topic of the dollar seems to have bubbled to the surface again. Down more that 10% from the December 2016 peak, the greenback has started to sag at just the time when Treasury deficits are climbing and the Fed is paring back its purchases of US government debt and agency mortgage bonds, as shown in Chart 1 below. With the 10-year Treasury back over 2.6% yield, gravity seems to have been restored to the global economy.
The last peak of the trade weighted dollar was in mid-2002, after which the US currency slid steadily into the 2008 financial crisis. Did investors and government officials outside the US perceive the approaching contagion? You bet -- but especially in China, where the political leadership understands the process of “dollar recycling.” Simply stated, if China stops buying US Treasury debt or other dollar assets, the surging yuan strengthens even more. And even as President Trump starts a trade war with China, the yuan is already soaring against the dollar. Duh?
Starting in 2008, the dollar climbed steadily even as interest rates and credit spreads remained suppressed. But from 2009 through 2011, the dollar actually gave back ground even as the Federal Reserve ramped up purchases of Treasury debt and mortgage securities via QE. By 2012, the flood of foreign capital pouring into US real estate and financial assets finally began to lift the dollar, which by 2014 began a sustained rise in value that finally peaked at the end of 2016, just after the election of Donald Trump. The peak in the dollar in December 2016 came after years when strong capital inflows helped to reflate the US equity and real estate markets, the latter both for commercial and residential properties.
But as prices for US stocks and real estate reached absurd levels, foreign purchases began to decline. In particular, changes in US tax rules for foreign investors in real estate as well as political changes in nations such as China have caused the dollar to slump over the past year, as shown in Chart 2 below. Notice that the yuan/dollar exchange rate and the dollar/euro rate have both seen the value of the dollar deteriorate over the past year under the leadership of Donald Trump.
Of course, some observers would blame the slump in the value of the dollar on President Trump, especially now that Treasury Secretary Steven Mnuchin is publicly lauding the benefits of a weaker dollar. In Davos, for example, Mnuchin said: “Obviously, a weaker dollar is good for us as it relates to trade and opportunities.” Secretary Mnuchin is said to think President Trump is an "idiot," but compared to what?
In reality the factor which seems to govern the movement of the dollar is not the pronouncements of Mr. Mnuchin but rather mounting federal budget deficits. The US deficit fell to “only” $438 billion in 2015 and has been growing substantially ever since. With the just passed tax legislation thrown into the mix, US deficits are expected to surge to more than 5% of GDP annually. Chart 3 shows the US fiscal deficit vs the trade weighted dollar.
It’s interesting to note that while President Trump and Secretary Mnuchin may think that they are driving the proverbial bus when it comes to the value of the dollar, in fact the deteriorating fiscal situation for the US seems to be the key determinant. Indeed, the passage of the tax legislation at the end of 2017 makes us somewhat more cautious about our bullish view of the 10-year Treasury, which now seems headed lower in price and higher in yield under the weight of expectations regarding Treasury debt issuance.
But while we may be less bullish on the 10-year Treasury bond, the curve flattening trade is still a very real scenario because of the Treasury’s huge debt issuance calendar. The fact that the Federal Open Market Committee is slowly allowing its portfolio to run off is an important factor in the analysis.
We continue to think that the Fed is being overly optimistic as to how quickly the late-vintage MBS in the System portfolio will prepay. Let’s review the questionable actions of the FOMC under Chairs Ben Bernanke and Janet Yellen from 2008 to 2014:
QE1 (December 2008-March 2010): The FOMC started with $600 billion in “sterilized” purchases of MBS (funded with sales of Treasury debt), then increased to a further $750 billion in outright purchases of MBS funded with excess bank reserves.
QE2 (December 2010-June 2011): Fed purchased another $600 billion in longer dated Treasury paper funded with bank reserves, extended duration of System portfolio.
Operation Twist (2011): The FOMC sold short term Treasury paper and bought longer dated Treasury maturities, significantly extending the duration of the System portfolio.
QE3 (September 2012-December 2013): FOMC committed to buy $40 billion per month in MBS and purchased an additional $45 billion in Treasury debt funded with excess bank reserves. Since then, increased interest rates and falling prepayments have extended duration of System portfolio.
The FOMC under Chairs Bernanke and Yellen did everything possible wrong in managing the System portfolio. Now the Fed is illiquid, trapped in a long duration position in a rising rate environment because they violated the cardinal rule of central bankers: stay short duration.
As we've noted previously, the FOMC dares not sell any of the System portfolio out of fear of generating losses. So the Mnuchin Treasury is planning to fund its spending deficits with short-term debt issuance, but the runoff from the Fed’s MBS portfolio may, in fact, be so slow that the central bank will not be able to purchase much of the Treasury’s new debt.
As the FOMC tries to rebalance the System portfolio back to 100% US government debt, it may take years longer than currently estimated by the Fed staff for the System MBS positions to actually runoff. This means that the full weight of Treasury issuance of short-term debt will hit the markets with no support from the Fed and at a time when the dollar is falling.
So the good news is that the FOMC has ended its long, strange period of social engineering known as QE. The bad news is that the Republicans in Washington have just cut taxes and the resulting red ink could see the US dollar test post-WWII lows. Because of fears regarding future deficits, the 10-year Treasury bond may not rally appreciably. Yet there remains a dearth of long-dated Treasury paper available in the markets, in part due to purchases by the FOMC.
The surprise for newly installed Fed Chairman Jerome Powell is that the short-end of the yield curve could surge above the Fed’s target for short-term interest rates once Treasury begins to seriously increase issuance to an expected deficit of 5% of GDP annually. By 2022, the annual US deficit could be a trillion dollars. And even with significantly higher short-term interest rates, the dollar may continue to fall under the weight of rising fiscal deficits and the falling credibility of the US government.
Doug Bandow stated the situation nicely in The American Conservative last week:
“The United States is effectively bankrupt, but that doesn’t matter to the GOP. Once evangelists of fiscal responsibility and scourges of deficit spending, Republicans today glory in spilling red ink. The national debt is now $20.6 trillion, greater than the annual GDP of about $19.5 trillion. Alas, with Republicans at the helm, deficits are set to continue racing upwards, apparently without end.”
So two questions: First, will the surge in US fiscal deficits cause short-term interest rates to rise and the dollar to fall faster than currently expected? Second, what happens to the overheated prices for stocks and US real estate in such a scenario?
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