The discussions this weekend at Leen’s Lodge in Maine were wide ranging and, as always, of great interest. Will Argentina’s economy implode? (A: Sadly yes). Argentina is trading at a discount to Uruguay. Will the commercial real estate market in the UK likewise collapse as the train wreck called Brexit unfolds? (A: In progress). When will the yield curve invert? (A: Soon).
One of the most interesting points of debate was the impact of the 2001 decision by the US Treasury to focus debt issuance on the front of the yield curve in order to minimize the debt service cost to the United States. Along the way, the question arose: Is the United States really a “AAA” credit?
Readers of The Institutional Risk Analyst know that we have recently been focused on how Fed policy has manipulated the pricing of the yield curve as well as private credit spreads. But so too has the Treasury’s decision almost two decades ago to limit issuance of 30-year debt affected the cost of credit and, at the present time, is exacerbating the flattening of the yield curve. On October 31, 2001, following the 9/11 attacks, Treasury Undersecretary for Domestic Finance Peter Fisher famously made the following statement:
“We do not need the 30-year bond to meet the government's current financing needs, nor those that we expect to face in coming years. Looking beyond the next few years, as I already observed, we believe that the likely outcome is that the federal government's fiscal position will improve after the temporary setback that we are now experiencing.”
But of course the Treasury’s fiscal situation did not improve. Since 9/11, continued profligacy in Washington has caused the federal debt to explode. As the surge of tax receipts generated by the aging of the baby boom have ebbed, the indebtedness of the United States has soared and with it the portion of US debt that is issued in short-term maturities. The 2017 tax legislation has only accelerated an already negative fiscal trend.
The General Accountability Office notes in its most recent audit that since fiscal year 1997 total federal debt has increased by 275 percent. Also during this period, the statutory debt limit has been raised 17 times. The GAO notes in its most recent audit report:
“Debt held by the public as a share of gross domestic product (GDP) was roughly 76 percent at the end of fiscal year 2017, down slightly from roughly 77 percent at the end of fiscal year 2016. Over the longer term, debt held by the public as a share of GDP is expected to grow as a result of the structural imbalance between revenue and spending. Federal spending on health care programs—driven by an aging population—and interest on the debt held by the public are the key drivers of growing spending in the long term… While today’s relatively lower interest rates have kept interest costs down, interest rates are expected to rise in the long term, resulting in increasing interest costs on the debt. The key drivers of spending will continue to put upward pressure on the budget. Absent action to address the growing imbalance between spending and revenue, the federal government faces an unsustainable growth in debt.”
On August 5, 2011, Standard & Poor's (S&P) reduced the US sovereign rating from AAA (outstanding) to AA+ (excellent), causing more than a little commotion among the economists and investment professionals attending Camp Kotok at the time. Panicked members of the financial media were seen desperately trying to acquire a cell phone connection in order to opine on the S&P action.
Of note, at the time of the rating action, S&P left the transfer and convertibility (T&C) assessment of the US at “AAA” in a reflection of the strong global acceptance of the dollar as a means of exchange. The fact of the dollar’s role as the reserve currency, as a means of exchange and also as a store of value for the citizens of smaller nations enables the US to largely escape the consequences of the libertine behavior of Congress.
Nations such as Argentina, Greece, Venezuela and Turkey feel the consequence of fiscal deficits in terms of T&C. Just as investors like to trade the equity of zombie banks like Citigroup (C) and Deutsche Bank (DB) because of liquidity, the world uses dollars because of universal acceptance and size. No other currency is big enough to support international trade flows for things like energy and capital goods, and also be the reserve currency for global finance. This is the key factor that enables the US to avoid the impact of increasingly absurd fiscal decisions in Washington.
As noted in the 2010 book “Inflated: How Money and Debt Built the American Dream,” Americans like to think themselves prudent in financial matters, but also have a libertine streak a mile wide. The purposeful citizens who a century ago survived depressions and wars have been succeeded by grandchildren who neither know nor understand practical limits to their wants and desires. Whether or not governments in China or Russia buy Treasury debt or not does not matter, for now at least, because the vast world of dollar finance will easily absorb the assets.
The slowly deteriorating credit standing of the US seems to prove the old judgment that Americans will always do the right thing after exhausting all of the other possibilities. For now the fact of dollar hegemony saves us from our collective idiocy – as when the Congress confiscates the assets of the Federal Reserve System to paper over what thin budgetary restraints remain. The Fed is the alter ego of the Treasury in financial and economic terms, a nuance that is happily ignored in Washington.
In 21st century America, members of Congress pretend that debt forgiveness by the central bank – aka “quantitative easing” -- is revenue. Members of the FOMC are notably silent on the question. When Americans reach the point of seeing debt-to-GDP for publicly held debt over 100%, then both S&P and the other rating agencies will be forced to start weighing quantitative fiscal factors more heavily. In terms of total debt, we're already there.
The special role of the dollar as a global exchange medium will come under greater pressure as the public debt grows. When and if the markets ever start to cool on dollars, the management of the Treasury’s debt issuance strategy may also come under scrutiny. Back in 2001, Peter Fisher outlined two possible but “less likely outcomes” for the US following the 9/11 attacks:
“First, it is possible that the federal government will return to significant and sustained budget surpluses even more quickly than we now expect. In this event, maintaining current issuance levels of 30-year bonds would be unnecessary and expensive to taxpayers.”
“Second, we face the possibility that sustained surpluses do not materialize as promptly as we now expect. If later in this decade it turns out that 30-year borrowing is necessary to meet the government's financing needs, it is still likely that our decision to suspend 30-year borrowing at this time will have saved the taxpayers money. In addition, the reintroduction of the 30-year bond, at some point in the future, if necessary, would likely be costless to the Treasury.”
In 2009 during the depths of the financial crisis, the Treasury temporarily reversed the Fisher decision and began to issue longer-dated securities. From an average maturity of just 45 months in 2009 the Treasury issued longer dated debt until the end of 2017, when the average maturity reached almost 72 months, Bloomberg reports. At one point Treasury Secretary Steven Mnuchin actually talked about issuing an ultra-long bond with a maturity of more than 30 years, but such ruminations have stopped with the end of QE.
Almost two decades since 9/11, the fiscal situation of the US has reached crisis proportions, but so far Washington is saved by the fact that the dollar is still the biggest game in town. The Fed’s experiment with purchases of trillions in Treasury debt, the kind of behavior seen from developing nations like Mexico and Argentina during the 1980s debt crisis, has also provided a huge subsidy to the Treasury. Congress may one day mandate such an expedient on a permanent basis. In the event, the pretense of Fed independence will be discarded with finality and America’s credit rating is likely to fall further.
The decision by Treasury in 2001 and more recently in 2017 to limit the duration of the Treasury’s debt, may have less efficacy in a world where central banks are manipulating interest rates and credit spreads. Or more to the point, if the Treasury today can borrow at 30 or 50 or even a hundred years at low single digit rates, why doesn’t Secretary Mnuchin do that trade?
Additional issuance of longer dated Treasury debt might counteract a flattening curve and restore spreads and profitability to many parts of the financial economy such as banking and housing finance. As we'll be discussing in future issues of The Institutional Risk Analyst, US banks are not profitable because they are making great spreads on loans or securities, but because of cheap funding -- an advantage that is rapidly disappearing.
Nations like Argentina and Turkey show the dangers of funding in dollars when you have a weak, small currency. Size matters. That is one big reason why the EU, China and Brazil have not been able to create an effective competitor to the dollar. Those remaining “AAA” sovereigns like Canada, Australia and Belgium have limited capital markets access. But if Americans manage to convince the rest of the world that we are libertines and appropriate subjects for ridicule, then size may become a considerable disadvantage.
As Mark Twain observed: “Suppose you were an idiot, and suppose you were a member of Congress; but I repeat myself.”
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.