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Investors fear a run on Treasuries and the dollar

In our view, the investment community may not yet be fully convinced by the dollar’s rally since July. The perversity of the currency at the epicentre of the global financial crisis appreciating so sharply since July is, to some, both unfair and unsustainable. Not only has the Fed begun to conduct quantitative easing (QE), but the US fiscal outlook may also seem precarious. (See The Fed’s QE Operations and the Dollar (November 26, 2008), in which we argued that it is US structural weaknesses, i.e., the reasons behind QE, rather than QE itself, that would likely weigh on the dollar.) Indeed, our colleague David Greenlaw expects total Treasury issuance to reach US$1.5 trillion in FY2009 (more than 10% of US GDP – see Budget and Treasury Financing Update: Time to Tally the Red Ink, October 31, 2008, by David Greenlaw). In an environment where reserves-rich emerging markets may have local needs for their financial resources and may still harbour doubts about the sustainability of the USD, some investors are justifiably worried about the fate of the USD as a result of the large fiscal deficits in the coming years.

Unlike the JGBs, the world already has so much exposure to US Treasuries that a severe deterioration in investor sentiment on them could, in theory, lead to large sales by foreign holders of these papers, triggering a rise in US long bond yields and a fall in the dollar. Some investors are concerned about these risks.

But There Are Several Stabilising Factors for the USD

The fiscal deficit-dollar nexus may actually turn out to be more stable than some may think. So far, the ability of the long-term yield in the US (and elsewhere) to fall, in spite of the well-recognised risk of an impending flood of new debt issuance in coming quarters, is a tentative indication that there need not be a run on US Treasuries, and therefore the USD. Here are some stabilising factors for US Treasuries and the USD (for related analysis by my colleagues, please see Do Global Financial Assistance Plans Menace Inflation and Sovereign Debt, Berner, Greenlaw and Miles, October 21, 2008):

• Factor 1. Recession is more powerful than surges in debt issuance. While it is true that, all else equal, more debt supply is negative for bond prices and positive for bond yields, all else is usually not equal. Surges in government debt issuance tend to coincide with the need to provide fiscal stimulus in recessions. (Indeed, in a study by the Federal Reserve (New Evidence on the Interest Rate Effects of Budget Deficits and Debt (April 2005) by Thomas Laubach), it was argued that, isolating the pure supply effect (by suppressing all other factors that may simultaneously determine the bond yields), “a one percentage point increase in the projected deficit-to-GDP ratio is estimated to raise long-term interest rates by about 25 to 30 basis points”.) This ‘simultaneity’ problem is more than technical. In the last four US recessions, the US 10Y bond yield has been positively linked to GDP growth. In other words, when the US economy decelerated into the trough of a recession, long-term bond yields fell. Conversely, when the US economy has climbed out of a recession, US long-term yields tend to rise. Thus, in general, variations in US bond yields have followed the business cycle. This historical regularity appears to be strong. In the case of Japan, the massive JGB issuances in the past decade were also accompanied by relatively low 10Y JGB yields.

• Factor 2. The US debt sustainability is not materially altered by the recent operations. In light of the massive size of the fiscal deficit the US is likely to have in the coming two years, as well as the expected rise in public debt burden associated with the demographic trend, there are now serious concerns about US debt sustainability. Over the medium term, it is clear that the US will need to tackle the fiscal issue aggressively. But, regarding the current fiscal stimulus, it may be useful to note that much of the fiscal deficit is linked to the financing of asset swaps, which should eventually be unwound, with some losses or profits. Further, to the extent that some of the actual spending on goods and services by the government is on infrastructure, the long-term productive capacity of the US economy could actually be enhanced, and the ‘crowding out’ effect mentioned above would not apply. Only large and sustained tax cuts and government consumption would lead to a ‘sustainability’ issue, in our view. Unlike individuals, large countries like the US need not ever fully pay down their debt. Debt service is considered sustainable as long as the real growth rate of the economy (g) is above the real interest rate (r) paid on the debt, i.e., as long as g > r over time, the public debt should be considered sustainable. In the US, the long-term average growth rate since 1950 has been 3.3%, while the average real long-term interest rate has been 2.6%. (Demographic and productivity trends could of course alter g, and the risk premium could alter r.)

• Factor 3. Potential demand for US Treasuries could be large. There has been much focus on the likely supply of sovereign bonds in the next year or so, but perhaps not enough analysis on the potential size of demand for these papers. The world’s real money community (pension funds, mutual funds and life insurance companies) had US$59.4 trillion in assets under management (US$22 trillion in the US, and US$20 trillion in Euroland) at the beginning of 2008. This compares with the US$5.7 trillion market for US Treasuries and €1.2 trillion (US$1.5 trillion) market for German bunds. A severe global slowdown accompanied by a sharp decline in inflation could tilt the portfolios of these funds in favour of bonds. Second, commercial banks could also become a major source of support for sovereign bonds. Japan is perhaps a useful example. Japanese banks have, as the economy has stagnated, curtailed traditional loans in favour of holding JGBs (we are grateful to our colleague Takeshi Yamaguchi for guidance with the Japanese data). Since 2000, holdings of government securities have risen from 9% to 20% of total bank assets, which are roughly ¥300 trillion (or some US$3 trillion). Banks’ holdings now account for 36% of total JGBs outstanding. Right now, US banks have about 10% of their assets (US$1.1 trillion) in government securities (down from 20% in 1993). Finally, the Fed could be the buyer of last resort, as was the case with the BoJ in its rinban operations during the QE period of 2001-06. In short, potential demand for US Treasuries could be substantial. Notice that we haven’t mentioned Asian central banks. Their participation in the Treasury market is important, but perhaps not as critical as some may think.

Bottom Line

Fears of a run on the US Treasuries and the dollar are understandable. However, we believe that US fiscal sustainability has not been significantly compromised by the recent operations – most of which are related to asset swaps rather than outright spending. Further, potential demand for US Treasuries could be substantial, particularly in a soft economic environment. Real money investors, banks and the Fed are three key sources of demand for US Treasuries, in addition to foreign central banks. We do not have a structurally negative view on US Treasuries or the US dollar.

Stephen Jen is a Managing Director and Chief Currency Economist. He joined Morgan Stanley in 1996. Stephen was the Asian Currency Strategist based in Hong Kong until September 1999. He is now based in London. Prior to joining Morgan Stanley, Stephen spent four years as an economist with the International Monetary Fund in Washington, D.C., primarily covering member countries in Asia and Eastern Europe. Stephen was actively involved in the design of the IMF’s framework to provide debt relief to highly indebted countries. Stephen has also worked for the Board of Governors of the Federal Reserve and the World Bank and has been a lecturer at the Massachusetts Institute of Technology and Georgetown University’s McDonough School of Business.

Stephen holds a Ph.D. in economics from the Massachusetts Institute of Technology, with concentrations in international economics and macroeconomics. He also holds a B.Sc. in electrical engineering summa cum laude from the University of California, Irvine.