Mar 21

The Obama Budget and the Dollar

Posted in US Dollar

Last week, the Obama Administration released its fiscal 2012 budget to much fanfare. Unfortunately, the budget makes only a token effort to address the rising National debt, and forecasts a budget deficit of $1.1 Trillion. While the release of the budget failed to make a splash in currency markets, traders would be wise to understand its implications for the future.

The budget proposes spending of $3.7 Trillion in 2012, and forecasts receipts of only $2.6 Trillion. As usual, entitlements (Social Security, Medicare, and Medicaid: $2 Trillion+), Defense ($760 Billion), and net interest on debt ($250 Billion) are projected to consume the brunt of spending. The Departments of State, Education, Energy, and Veterans Fairs will receive an increased allocation, while almost all other Departments face drastic cuts. (For more comprehensive breakdowns, the WSJ and NY Times offer excellent graphical representations of how the federal budget is funded and disbursed).

The proposed budget allows for a deficit of $1.1 Trillion (7% of GDP), which unbelievably represents a significant decrease from the $1.6 Trillion (11% of GDP) that is projected for fiscal 2011. The Congressional Budget Office (CBO) forecasts the deficit to return to a more “sustainable” level of 3% of GDP beginning in 2014, which should allow the national debt to remain constant in relative terms for the following decade. Beginning in 2021, however, entitlement spending is projected to skyrocket, which would cause debt to rise similarly.

CBO projections are based on a handful of rosy assumptions. First of all, it assumes that the US economy will grow at 3%+ for the indefinite future. Second, it assumes that deficit spending can be financed at reasonable interest rates. Third, it assumes that tax receipts will rise from current lows and revert back to historical levels. Given the ongoing economic uncertainty, high unemployment rates, tax cuts, rising interest rates, the difficulty of cutting spending, etc., there is reason to believe that actual deficits will be even higher.

In fact, net interest payments on national debt will rise 33% over the next year even as Treasury rates remain at record lows. If the economic recovery gathers momentum (something that the budget is counting on), risk appetite and interest rates must rise. In addition, given that the national debt will probably double from 2009 to 2012, it seems likely that investors will demand an increased risk premium for lending to the US. On the other hand, demand for Treasury Securities continues to remain strong: “Net long-term securities transactions showed total buying of $65.9 billion in long-term U.S. securities in December, after purchases of $85.1 billion the month before.” Many Central Banks continue to be net buyers.

In addition, there are some commentators that think the Fed will abet the US government in deflating the real value of its debt. Since the majority of US Treasury Securities are not inflation-protected, 15 years of high inflation (~5%) would be enough to decrease the real debt burden by half. Especially when you account for “contingent obligations,” this might be the only feasible way for the government to deal with its debt burden over the long-term. Then again, higher inflation would probably drive proportional increases in yield, such that the Treasury Department would have a tough time rolling over existing debt (let alone in issuing new debt) at reasonable interest rates.

The main variable in all of this is politics. Specifically, this budget is still only a proposal. The actual budget won’t be ratified for at least another six months, and only after tense negotiations with the Republican Party. (There is also the possibility that it won’t be passed at all, which is what happened with the fiscal 2011 budget). “House Majority Leader Eric Cantor, a Virginia Republican, said his party will propose ‘very bold’ changes to entitlements in their 2012 budget resolution.” Anything short of this wouldn’t dent the projected deficits and would push Social Security / Medicare closer towards the brink of insolvency.

In the end, the deficit merely represents business as usual for the US government. Barring a double-dip recession, it probably won’t be enough to seriously impact the Dollar’s status in the short-term as preeminent global reserve currency. However, that could start to change over the next decade, as the government either takes steps or does nothing to mitigate the looming entitlements crisis. At that time, the long-term viability of the Dollar (and the financial system as we know it) will become clear.

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Nov 14

Does Japan’s “Triple Disaster” Threaten the Dollar?

Posted in US Dollar

While analysts have been busy dissecting the implications of the natural disasters that ravage(d) Japan for forex markets, the focus has naturally been directed towards the Yen. Given all the rumors about the liquidation of foreign (i.e. Dollar-denominated) assets, it’s also worth examining the potential impact on the Dollar. In a nutshell, Japan’s holdings of US Treasury Securities are extensive, and even a partial unloading could have serious implications for the world’s de facto reserve currency.

As I explained in my previous post, the Yen rose to a record high (against the Dollar) following the earthquake/tsunami/nuclear crisis because of rumors that Japanese insurance companies and other financial institutions would begin repatriating all of their foreign assets in order to pay for rebuilding. (For the record, it’s worth pointing out again that this has yet to take place, and any repatriation is probably related to the approaching fiscal-year end. Thus, the Yen is being propelled by speculation/short squeeze. Period.)

Indeed, Goldman Sachs has estimated that the rebuilding effort will probably cost around $200 Billion. A significant portion of this will no doubt be covered by the payout of insurance claims. How insurance companies will make their claims is of course, unknown. However, consider that Japanese insurance companies have insisted that they have ample cash reserves. In addition, Japan has what is perhaps the world’s most solid earthquake reinsurance (basically insurance for insurers) program, which means primary insurance companies can basically pass these claims up the chain, perhaps all the way to the government.

As for whether the Bank of Japan will sell some its $900 Billion in Treasury holdings, this, too appears unlikely. First of all, the Bank of Japan is doing everything in its power to soften the upward pressure on the Yen, which would not be consistent with selling any of its Dollar-assets. Second, the Financial Times has further argued that they will be especially unlikely to sell US Treasury securities, because they would lose money on (US Dollar) currency depreciation. Besides, any assets that are sold now to pay for rebuilding would probably need to be repurchased later in order to restore balance sheet equilibrium.

While I am on the topic, I want to draw attention to a recent Treasury report that documented the overseas holdings of Treasury securities. The major surprise was China, whose holdings were revised upwards to $1.18 Trillion (from $892 Billion), which means it is well-entrenched as the most important creditor to the US. However, this was offset by a 50% drop in the Bank of England’s holdings, caused perhaps by a change from US debt to British debt.

As I have written in the past, it seems unlikely – for political, economic, and financial – reasons that China will move to pare its Treasury holdings in a significant way. Simply, it has no other viable options for investing the foreign exchange reserves that it is forced to accumulate because of the Yuan-Dollar peg. Other doomsdays have speculated that the crisis in the Middle East will end the “petro-Dollar” phenomenon, whereby oil exporters settle their bills almost exclusively in Dollars and use the proceeds to buy Treasuries. While US influence in the Mid East may indeed wane further as a result of the ongoing political turmoil, I don’t think this will force a change to the PetroDollar phenomenon, which is due as much to unavoidable trade surpluses as it is to settling oil transactions in US Dollars. 

There is certainly some concern about what will happen when the Fed wraps up QE2 later this year and stops buying Trreasury securities. Two prominent investment companies (PIMCO and Vanguard) have warned that this will cause bond prices to fall and interest rates on debt to rise rapidly. While this is certainly possible, demand for Treasuries will remain strong for as long as the current risk-averse climate remains in place. In addition, given that the US Treasury is not in danger of defaulting anytime soon, yields reflect expectations for inflation and interest rates more than supply/demand for the bonds themselves. Finally, when the Fed stopped buying mortgage backed securities in 2010, mortgage rates fell, contrary to expectations. 

In short, the Dollar might continue to fall against the Yen as speculators cover their short positions, but not because of any fundamental reasons. On an aggregate basis, the never-ending string of crises won’t cause the Dollar to collapse. If anything, it might even bring some risk-averse capital back to the US and re-affirm the Dollar’s status as global reserve currency.

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