With the global financial punditry assembled in Davos this week, the topic of the dollar seems to have bubbled to the surface again.
Down more than 10% from its December 2016 peak, the greenback is sagging at just the time when Treasury deficits are climbing and the Fed is paring back its purchases of U.S. government debt and agency mortgage bonds. 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 U.S. currency slid steadily into the 2008 financial crisis. Did investors and government officials outside the United States 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 U.S. 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 quantitative easing (QE).
By 2012, the flood of foreign capital pouring into the U.S. equity and real estate markets finally began to lift the dollar, which by 2014 began a sustained rise in value that peaked just after the election of Donald Trump.
But as prices for U.S. stocks and real estate reached absurd levels, foreign purchases began to decline. In particular, changes in U.S. 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. The yuan/dollar and dollar/euro exchange rates have both seen the value of the dollar deteriorate during the Trump administration.
Of course, some observers would blame that slump on the president, 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.” Mnuchin is said to think President Trump is an “idiot” — but compared to what?
In reality, the factor that seems to govern the movement of the dollar is not the pronouncements of Secretary Mnuchin but rather mounting federal budget deficits. The U.S. 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, U.S. deficits are expected to surge to more than 5% of GDP annually.
It’s interesting that while Trump and Mnuchin may think they are driving the proverbial bus when it comes to dollar’s value, in fact the deteriorating U.S. fiscal situation seems to be the key determinant. Indeed, the recently passed tax legislation 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 the curve-flattening trade is still a very real scenario because of Treasury’s huge debt-issuance calendar. The fact that the Fed’s Federal Open Market Committee is slowly allowing its portfolio to run off is an important factor in the analysis. We continue to think the Fed is being overly optimistic as to how quickly the late-vintage mortgage-backed securities (MBS) that it bought up will prepay.
Let’s review the 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): The Fed purchased another $600 billion in longer-dated Treasury paper funded with bank reserves.
Operation Twist (2011): The FOMC sold short-term Treasury paper and bought longer-dated Treasury maturities, significantly extending the duration of the FOMC portfolio.
QE3 (September 2012-December 2013): The FOMC committed to buy $40 billion per month in MBS and purchased an additional $45 billion in Treasury debt funded with excess bank reserves.
The FOMC dares not sell any of that portfolio, for 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 portfolio back to 100% U.S. government debt, it may take years longer than the Fed currently estimates for the 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 U.S. dollar test post-World War II 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 U.S. 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 U.S. 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 U.S. 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 U.S. real estate in such a scenario?
Christopher Whalen is chairman of Whalen Global Advisors, a provider of investment banking and consulting services to institutional investors and corporate clients worldwide. This article was initially published in Whalen’s online publication, The Institutional Risk Analyst. It is reprinted here with Whalen’s permission.