Oppenheimer Redux

 “We don’t know what to do. It’s really a throw-the-kitchen-sink-at-the-problem strategy”

 Kenneth Rogoff
former Chief Economist at the International Monetary Fund

We have been trawling through the usual year-end smorgasbord of predictions, prognostications and punditry. We have reviewed the usual plethora of numerical price targets, the sectors to watch out for and the hot stocks and so on but have come away from the table feeling a little empty.

Therefore we have to say “Thank You” to Professor Rogoff for his frank admission that the authorities have been fumbling in the dark for answers to the problems they ignored until it was too late.

In our view what most of these commentators are missing, (with the exception of Ken Rogoff and a few others) is the fact that the markets are still in fundamental disequilibrium. Nothing has been solved. The size, scale and prioritization of the financial policy issues that need to be dealt with is still far from being clearly reflected in the policy responses we have witnessed to date.

Significant, unprecedented risks to the system remain and we observe that whether the Western economies will emerge from this debacle relatively intact and soon; or, whether additional painful and extenuated maulings are in store is a Big Picture question that hinges on expectations regarding the level of US Treasury yields, the debt calendar, the dollar exchange rate and their combined effect on saving and spending decisions the world over. These critical factors will overwhelmingly drive investor expectations and activity in the months and quarters immediately ahead in all markets.

Buy Bonds for Paulson

Yields on US Treasuries have plummeted to historic lows. The 10 year Note currently pays a scant 2.25 %, a level that is below the rate of inflation, placing real investor returns in negative territory. Yields on T-bills are zero, meaning that Investors in those instruments are in effect financing the US Government at no cost to it and costing investors even greater negative returns in the process.

In September Hank Paulson announced the TARP aimed at averting catastrophe in the financial markets – price tag: USD 800 billion (USD 700 billion plus the add-ons and the pork). This, in combination with slowing tax revenues and new stimulus initiatives already in the works by the incoming Administration, will boost the US national debt by as much as USD 2.0 trillion in fiscal 2009 – an unprecedented increase in Treasury supply.

Currently US Federal Government funded debt stands at a shade under USD 11.0 trillion or a little over 70 percent of gross domestic product. Approximately 40 percent of this total is short term, meaning that it will mature in under one year. (Note that the short term debt includes not only current “on-the-run” Bills and cash management instruments but also significant quantities of seasoned Treasury Notes and Bonds which had original maturities of up to 30 years)

This means that in the next year the Federal Government will have to roll over about USD 4.3 Trillion of Debt on top of the estimated USD 2.0 Trillion of new financing.

Assuming that there are no more financial shocks, tax cuts or new spending initiatives, the debt managers at the Treasury have been tasked by their Fearless Leaders to find buyers for around USD 6,300,000,000,000 of US paper within the next twelve months. This is unparalleled by an extremely wide margin (and extremely inopportune for reasons discussed immediately below).
 
 
Care and Feeding of the Golden Goose

For years the US has typically enjoyed lower debt financing costs than other nations at every point on the yield curve. In addition, despite running high trade deficits the US was able to fund its fiscal and trade requirements effortlessly due to an “Entente Cordiale” between it and the countries with which it runs a trade deficit. The basic deal has been: We (the US) will buy your goods and in some cases provide a security guarantee and other multinational goodies (support for WTO membership and so on), and you (the surplus country) will buy our Treasury debt securities (and do us other favors). The ability of the US to cut these deals has relied not only on the fact that since 1971 the US Dollar has functioned as the World’s reserve currency, it is also because the US exercised (mostly) sober political leadership, has the World’s largest, most liquid and most (arguably) transparent capital markets, effective control of key multinational institutions and an overwhelming military capability.

Historically, the US could therefore borrow what it wanted at prices set by it regardless of the wisdom or efficacy of the economic policies it was following. In economic terms this meant that the supply schedule for imported funds into the US had zero slope, i.e. it is invariant with respect to the level of the USD, US interest rates or US funding demand.

As with any mechanism, this will work fine until it stops working.

This Postwar status quo ante has led most commentators and analysts to assume that this time around it will also be business as usual. These pundits maintain that because Japan ran large deficits in the 1990’s at negative real interest rates with no problem and no impact on the currency that it will be relatively simple for the US to achieve this feat. We beg to differ. Japan was able to do this because:

• Japan has a very large, persistent Trade Surplus. The US Trade Deficit is running at over 5% of GDP;
• Japan has a very large supply of domestic savings which soaked up all of the government debt supply through captive issuance channels (Kampo, Yucho and the domestic financial institutions). Short of printing money, the US is dependant on foreign investors to finance ongoing activity; and
• In terms of timing, Japan was alone in experiencing its own bubble and bust. The US is at the center of a Global Maelstrom which is laying claim to a chunk of everyone’s pot of savings.

To this we add that the recently rising USD and coincident low Treasury yields are a consequence of some very temporary factors in the marketplace.

•  The $700 Billion Lehman bankruptcy. Lehman had operations in dozens of countries. US Bankruptcy law requires that the bankruptcy trustees must consolidate the assets in the US or US controlled jurisdiction and in USD. Naturally this has boosted demand for USD in the short term;
• Repatriation of overseas assets by US private investors and institutions reacting to price declines and volatility in the US markets. (The flip side of this was the massive sell-off in many emerging and overseas markets in sympathy with the US.) This has also ramped spot demand for USD;
• The flight to quality by investors dumping toxic MBS and other structured paper;
• The parking of all of this cash in US Treasury Bills, Notes and Bonds sending their yields to historic lows;
• Parenthetically, the forced deleveraging has also hit other asset markets that were being propped up by large speculative positions held by banks, hedge funds and others that are now in liquidation because of the credit squeeze: Energy, Hard and Soft Commodities, Life Settlements, Corporate bonds, Municipal Bonds (You name it!)

What the current configuration of US Interest rates and currency values essentially means is that we are in a bubble which has arisen in part because of policy actions taken to combat the deflating sub-prime bubble. It is an aftershock, not an equilibrium state of affairs.

Pax Americana under Threat

In a fiat currency world it all comes down to confidence. And in a world where you are running a deficit profile of staggering proportions it all comes down to the confidence of foreign investors.

The “by-the-book” policy prescription for banking crises is for the Central Bank to raise rates, not to lower them. Higher interest rates are needed to ensure that foreign investors continue to supply credit to the debtor country. This policy move is typically supplemented by measures to shore up system liquidity using Central Bank support. Weak institutions are allowed to fail or are forcibly merged thus cleansing the system of the detritus and excess which led to the crisis in the first place.

The Fed and other Central Banks globally have done pretty much the exact opposite of this – they have cut rates and propped up most of the zombies. Foreign investors (Governments and Institutions) are now being asked to continue financing yawning US deficits at zero or negative real yields.

We submit that this state of affairs is fundamentally unstable, unsustainable and financially very risky.

Therefore, look for the following to occur in the coming months and quarters :

•  The US will be unable to achieve issuance levels of its debt in sufficient quantities along the yield curve to keep its Fixed/Floating exposure ratios within acceptable bounds. (The usually acceptable range of a Fixed/Floating mix is between 60/40 Fixed/Floating and 80/20 Fixed/Floating. The US is already at the outer bound of this range at 60/40. A higher proportion of floating issuance will mean even greater sensitivity of debt servicing costs to short term rates. For a wider discussion of Sovereign debt management go here on the Recovery Partners website)
• There will be failed Treasury Auctions. (Can’t believe it can happen in the US ? It already has, in the mid-90’s when I was a sovereign debt manager myself in an OECD country.)
• Interest Rates will rise along the Yield curve except where the Fed has most influence: one month and under. The yield curve will steepen considerably;
• The USD will sell off against the currencies of other countries whose financial policies are deemed to be more sensible or stable than those of the US; and, importantly, it will also depreciate in commodity terms; 
•  The US may decide to print money to “buy” its way out of the situation. Bernanke has already indicated that he will not hesitate to do this;
•  In the extreme the US may have to fund itself in currencies other than the USD because foreign investors go on “strike” until it cleans up its problems or provides them with a new “deal”. The key overseas debtholders here are China (25%), Japan (20%) and the UK (5%) who together own around 50% of US foreign held debt. (This latter development would be very serious and likely only occur after a period of significant geopolitical stress. If it did occur, the second order outcomes would likely include more geopolitical stress and unpredictability, probable domestic unrest and significantly increased incidences of adventurism by the usual cast of rogue states.)

“The ice age is coming, the sun is zooming in
Engines stop running, meltdown expected and the wheat is growing thin
A nuclear error, but I have no fear
London is calling – and I live by the river”

The Clash “London Calling” (emphasis added by Recovery Partners)

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