Domesticating the debt | FT Alphaville

Domesticating the debt

Forget Europe’s PIIGS. How about the big (American) hog?

Bob McKee of Independent Strategy, and author of ‘Sovereign DisCredit,’ makes the case in an eight-page note out on Wednesday. It’s worth taking a look given recent machinations in the US Treasury market — including a Tuesday sale of three-year US Treasuries which saw the lowest demand from long-term and foreign central bank investors in over three years.

Here’s the thrust of McKee’s piece:

Debt sustainability has been breached in many EU countries and not just the Eurozone ones: for two basic reasons, often, (but not always) acting in tandem. One is profligate states spending much more than they raise in tax and then spending it badly, leading to a pure sovereign debt crisis. That’s Greece, for example. The other root cause is excessive private sector debt and asset bubbles that dwarf the local economy and swamp the sovereign balance sheet with risk transferred from the financial sector. That’s Ireland and Spain. Portugal is a little of each. Belgium excels at both! … What is shocking is that these variegated symptoms of Europe’s debt disease are also to be found when we examine the spots on the US patient.

We’re going to set US debt metrics aside for one second — because we think the uneasy state of America’s public finances are fairly well-known at this point. What is interesting is how America’s debt levels have been sustained so far.

As McKee points out — high debt-to-GDP ratios can exist for a long time provided they’re financed domestically by a relatively high-saving population — like Japan. The US, he claims, has recently “stumbled upon an artificial method to domesticate its debt” — via quantitative easing and certain stimulus measures.

But the worry is that this ‘domestication’ will only work for a limited amount of time:

… there is the US dollar’s role as a global reserve currency. This recycles the current account deficit dollars that the US haemorrhages. Those dollars buy government and agency debt. Originally, this feedback loop was voluntary, based on the belief that the US economy was a good investment. But now it is involuntary because foreign holders of treasuries cannot sell them, or even stop buying them, without taking a considerable loss on the stock they own. So bad money follows good.

Second, the dependence on foreign purchases of US government debt has been reduced. The Federal Reserve has launched a series of QE asset purchasing schemes to buy US treasuries. At the same time, the Fed has provided cheap liquidity to the banks. In turn, they have bought government bonds.

And the federal government introduced fiscal stimulus programmes that subsidised household incomes, allowing households to save more and buy more bonds. But this ‘domestication’ will not last. The US remains, at heart, a low-savings economy. Already, foreign holders of US dollar assets have begun to ‘diversify’. The share of China’s FX reserves held in US treasuries is steadily falling. The fiscal and monetary support for domestic buying of US treasuries will come to an end by June, when the Fed’s QE programme ends and nearly all the government’s fiscal stimulus has been exhausted. Then US government debt issuance will have to be absorbed by the bond markets alone. They might then recognise the US hog for what it is.

The US will auction off $16bn worth of 30-year bonds on Thursday.

Related links:
Bloodbath of the bonds – FT Alphaville
Credit where it counts? – FT Alphaville
Coming to America, Greece-style – FT Alphaville