Most of the fear of what might happen if the US goes over the proverbial fiscal cliff has concentrated on the size of the economic drag it would produce.
But as you might have guessed for a blog that has long worried about the effects of a decline in safe assets on trust in financial intermediation, shadow banking liquidity, collateral shortfalls in money markets, etc… we also think it’s important to look at what it would mean for the corresponding decline in US Treasury issuance.
Chart and commentary via SocGen:
Under the current law, net new issuance of Treasury debt is projected to shrink from $1.2tn in the current fiscal year, to about $700bn in FY’2013 and $370bn by FY’2015. The 40%-plus drop in supply, along with the likely hit to the real economy, would be undoubtedly bullish for Treasuries.
At the other extreme, extending current tax and spending policies would keep the annual supply above $1tn through the end of the decade (and beyond). This is unlikely to be a problem for Treasuries in the near-term, but over time this scenario could put upward pressure on long-term interest rates, with negative consequences for potential growth.
And to gratuitously tack on something for anyone worried about a “buyers’ strike” (though given where yields are, we haven’t heard much about it lately)…
In the near- and medium-term, the US should continue to benefit from global excess savings and limited alternatives that match the depth and liquidity offered by the Treasury market. This means that the dollar’s reserve currency status will only be eroded gradually.
Examining the ownership structure and recent flows in the Treasury market can give some further indication as to sustainability of demand.
Over the course of calendar year 2011, the Fed was the largest buyer, absorbing nearly 60% of net new issuance, followed by US financials at 40% and foreigners at 27%. US households were net sellers, reversing the accumulation of government bonds that occurred from 2008 through 2010.
In times of economic uncertainty, fiscal contraction increases the gap between the demand for safe assets, which climbs, and their outstanding supply, which shrinks.
The US might not be in a financial crisis anymore, but it just came out of one and we would categorise the unemployment situation as an ongoing economic crisis — and Europe obviously is in a financial crisis, making it too early to start doing the exact opposite of what Bagehot said.