So said DoubleLine Capital founder Jeffrey Gundlach last week. We have repeatedly pointed-out that raising deficit spending near the end of an economic cycle, with the Fed tightening policy, is unprecedented. Moreover, raising the cost of borrowing when the U.S. is going to account for over 75% of developed-country government borrowing over the next five years, with personal saving rates near historic lows (having fallen from over 6% in October 2015 to 2.8% in April 2018), and with the U.S. being the world’s largest debtor nation to the tune of $7.8 trillion, strikes us as unwise. And, entering into a trade war with all your major trading partners at the same time you are so dependent on foreign capital and “the kindness of strangers” is even harder for us to reconcile.
Last week, we wrote that the Fed’s tweak to the interest it pays on excess reserves (IOER) is one sign that it recognizes that tightening policy at the same time that the Treasury is issuing more debt might be straining the availability of dollar funding globally. The Financial Times carried an article last week, headlined “Fed Tweak Hints at Limits to Shrinking Balance Sheet,” which pointed to the possibility that the Fed may, at some point, have to buy Treasury bonds again:
Seth Carpenter of UBS estimated that the balance sheet would probably not go below $3.5 tn [from the current $4.3 tn], a level it would hit in mid-2020. But given that officials have indicated that they want to get the Fed’s holdings of mortgage-backed bonds to zero, that would mean the Fed would actually have to start buying Treasuries again around then to counteract continued mortgage bond shrinkage. “It could be even earlier, depending on where they want excess reserves to settle,” Mr. Carpenter said.
For what it’s worth, the U.S. dollar index has risen just 1.1% over the last four weeks since the May 23rd announcement of the IOER tweak, well down from a 5.1% gain over the prior five-plus weeks, which indicates that strains on dollar-funding availability may be easing despite the well-publicized difficulties in emerging-market currencies.
This brings us to risks posed by the U.S. Net International Investment Position, or NIIP (see WILTW December 21, 2017) and the impact of fiscal policy changes on the trade balance (see WILTW March 1, 2018). As Brad Setser, senior fellow at the Council on Foreign Relations, argued earlier this year, the U.S. fiscal policy expansion could cause more capital to flow to other exporting countries because the closer that the U.S. operates near capacity, the only way to meet the additional domestic demand is to raise imports.
The empirical data appear to support this line of reasoning: U.S. real net exports of goods and services fell by 9% between September 2017 and March 2018, from minus-$597.5 billion to minus-$650.9 billion. This happened because real imports grew at almost double the pace of real exports—$113.8 billion to $60.5 billion. Meanwhile, the cumulative U.S. fiscal deficit during those two quarters nearly topped $600 billion—some of which most likely leaked outside the U.S. As tariffs on steel and aluminum imports, among other items, take hold—and U.S. trading partners retaliate—will the value of net exports fall even further? And, if so, will Trump respond by talking the dollar down to counteract the currency-devaluations of the ECB and the PBOC (see section 1)?
This begs another important question: as U.S. trade policy and foreign policy becomes increasingly confrontational, will other countries continue to support the Treasury market? The U.S. NIIP exploded from minus-$1.3 trillion at year-end 2007 to minus-$7.8 trillion year-end 2017—never before has one country owed so much to the rest of the world. CNBC recently reported that Russia cut its Treasury holdings in half in April, from $96.1 billion to $48.7 billion, while China reported a $5.8 billion reduction and Japan a $12.3 billion reduction.
This comes at an inopportune time because the list of potential buyers for U.S. Treasuries is shrinking, as we highlighted in WILTW March 8, 2018. Peter Boockvar, CIO of Bleakley Advisory Group, recently opined: “We need all the help we can get in the search for buyers of U.S. Treasuries due to the enormous supply coming our way in the next few years. Our stance on trade with our trading partners could very well play into this in coming months and quarters, especially with China, the largest owner of US Treasuries.”
While many argue that higher U.S. interest rates could attract greater flows of capital to the U.S. dollar, one could counter this argument by saying that the strong headline performance of the U.S. economy has largely been driven by copious amounts of borrowing. For instance, U.S. credit to the non-financial sector (according to BIS figures) grew 47% between 2007 and 2017—from $33.1 trillion to $48.7 trillion, or a gain of $15.6 trillion—while annual nominal GDP grew only $4.9 trillion during that time. In other words, the U.S. added more than $3 of incremental debt for each incremental dollar of GDP.
In stark contrast, the eurozone’s comparable level of debt, according to BIS data, grew only 15% over the past decade, or $4.5 trillion, to $34.6 trillion in 2017. Over the last five years, the differential was even more glaring: U.S. non-financial debt grew by $7.9 trillion, compared to a gain of only $370 billion for the crisis-impacted eurozone. For sure, the U.S. economy has performed better than the eurozone’s, but one could strongly argue that the disparity occurred largely because the U.S. added multiples of debt compared to the eurozone.
The recent tax cuts, while supportive of faster GDP growth, also require taking-on more debt to balance the federal budget. In other words, this growth comes at a cost, but that cost is rarely mentioned in the narrative surrounding the U.S. economy. And, with the personal savings rate at 2.8%—among the lowest in the developed world and less than one percentage point above its historic low—the margin for error is getting thinner at a dangerous time. If the Fed continues raising the cost of borrowing, it could imperil this debt-driven expansion by reducing the propensity to add additional debt.