Between the election of Barack Obama and the afternoon of June 10, the yield doubled to 4% from 2% for 10-year Treasury notes, the benchmark for long-term yields in the U.S. economy. Part of the sharp rise in yield was a snapback from levels that reflected fear of a deflationary breakdown of the banking system in the aftermath of Lehman Brothers’ failure last August. The improvement in the economic outlook from hysterical misery to ordinary happiness, paraphrasing Freud, add about six-tenths of a percentage point to the Treasury yield, as measured by the increase in the yields of inflation-indexed Treasuries. Most of the two percentage point rise in Treasury yield stemmed from rising fear of inflation or decline in the dollar, which amount to the same thing.
Obama’s stimulus package and associated handouts to the auto industry, banks, and so forth have endangered the credit of the US and damaged the standing of the US dollar.
With the Treasury’s annual deficit financing requirement approaching an unheard-of $2 trillion, the largest international investors in Treasuries have expressed dismay about the threat to the long-term value of their investments. Although the measures taken to date by America’s creditors are purely symbolic, they also are without recent precedent, and bode ill for the recovery prospects of the US economy. Today several foreign central banks announced plans to purchase International Monetary Fund bonds denominated in a basket of currencies, as a diversification away from dollar reserves. Bloomberg News reported, “Russia and Brazil, seeking to reduce their dependence on the dollar, announced plans to buy $20 billion of bonds from the International Monetary Fund and diversify foreign-currency reserves. Russia’s central bank said it may cut investments in U.S. Treasuries, currently valued at as much as $140 billion, a week after China said it may reduce reliance on the dollar and American bonds. Brazil’s Finance Minister Guido Mantega said his country will purchase $10 billion of debt sold by the IMF, China will buy $50 billion and India may announce similar funding.”
Just how does America finance a $1.8 trillion deficit? The most that overseas investors ever have invested in the US in a year is $400 billion, and it is unlikely that foreign governments will purchase this quantity of Treasury debt under present conditions. Assuming (optimistically) that foreigners buy $300 billion worth of Treasuries per year, that leaves $1.5 trillion to finance. For the American private sector to finance $1.5 trillion worth of Treasury debt, or about 11% of GDP, presumes a savings rate of 11% of GDP, something America has not seen since the early 1980s. The present recession has pushed the personal savings rate up to 6%, with painful economic consequences.
But even a return to the very high savings rates of the early 1980s would barely cover the Treasury’s financing needs. There would be nothing left over for corporate debt, mortgages, or any other financing requirements.
The economy, of course would crash under these circumstances. To make up the gap, the Federal Reserve has increased its balance sheet to provide credit to the economy by over $1 trillion since last August, including $600 billion of securities purchases.
The Federal Reserve can’t keep monetizing debt, that is, printing money in order to buy securities. The perception that it is coming close to the end of its tether is the proximate cause of the jump in interest rates.
Whether this results in more deflation (collapse in demand in the US resulting in lower asset prices, lower wealth, and ultimately lower prices for goods and services) or inflation (money printing by the Fed, a collapsing dollar, and an exchange of paper for stores of value in the form of commodities or other tangible assets) is difficult to predict the market seems to be betting on the latter. In either case, Obama’s maneuvering room has been exhausted only a few months into his administration.