A Lesson in Market History: "Should I Worry About Massive U.S. Deficits?"

Hedgeye Subscriber: The Fed was sounding hawkish but yields continue to go down even as the market expects the deficit to blow up in the U.S. Any thoughts?

Keith McCullough: The market should expect the deficit to blow-up in a lot places. A lot of countries have twin deficits (i.e. budget deficits and current account deficits).

Darius Dale: The vast majority of them do.

McCullough: Furthermore, the Fed’s balance sheet has been blowing up for as long as I’ve been in this business. It’s much more about the problems that happen as a result of growth slowing.

So look at the deficit historically. The deficit alone, as a single factor, is not a predictor of the U.S. Dollar. 

Pull up slide 79 from the current Macro Themes deck. See this, in the 1980s, with this guy Reagan. This is called a deficit rising, fiscal expansion.

McCullough: What was the dollar doing during that period (the green line)?

Dale: Rising. Ripping actually.

McCullough: To its all-time post-World War II high.

Now, it is important to understand what else was happening in the world back then. Why? Everything is relative. Einstein taught you that. And it’s not just the deficit that matters. It's not just one factor. Mandelbrot taught you that.

It’s multi-factor, multi-duration all the time.

So, if you’re a single-factor deficit investor and you expect the U.S. economy and the U.S. dollar to blow up because of widening deficits, you’re going to have a really hard time. You’d be wrong looking back historically at this single factor.

What was going on in the world back then? In the 1980s the U.S had monetary tightness, fiscal expansion, and relative growth accelerating against global growth which was slowing. That’s why the dollar was accelerating.

This is another way say that whatever your political proclivity is, it may not be right. That’s important. We don’t want to be political. We don’t want to be wrong. And we want to debunk narratives that Wall Street likes to talk about.

Dale: I love the phrase debunking narratives. I’m going to take it one step further. If you read the slide from our Q2 Macro Themes deck that we published at the beginning of April, it says “Exercising Exorbitant Privilege.”

The caption reads, “The U.S. dollar remains the world’s primary reserve currency and U.S. Treasuries remain the world’s primary reserve asset, which means if the U.S. needs capital, it gets capital. The Dollar has historically led meaningful changes in the capital account as a result.” The U.S. does need capital right now. The Fed is selling down $50 billion per month and the U.S. budget deficit is expanding.

The one thing Keith didn’t mention was the blue line. When the U.S. twin deficit balance meaningfully widens it tends to create this vacuum and a great sucking sound in global capital markets. What happens? A lot of cash gets repatriated to plug these deficit gaps that the Fed and Treasury are creating.

I think this is what's creating a lot of consternation and volatility in Emerging Markets, alongside a lot of the cyclical dynamics as well.