SEMI-MONTHLY FISCAL/MONETARY UPDATE – A FEW CHARTS ARE WORTH THOUSANDS OF WORDS
The last two weeks have been especially volatile in the capital markets, down sharply the week before last, a partial recovery last week, and downside volatility resumed this morning. Interest rates have ratcheted up, with the ten-year treasury note now yielding about 2.9%, more than double the low about eighteen months ago. There has been a belated and appropriate (in our view) concern by both political parties about the prospect of a US spending deficit once again approaching ONE TRILLION DOLLARS in the fiscal year ending 9/30/18 and even more next year. At the same time, the US Dollar has been very weak, an unusual response to higher interest rates in the US, which would normally attract international funds and strengthen the dollar.
Recall that, the US Fed, after building its balance sheet to over $4.2 trillion dollars (that’s a lot of money) from 2009 to 2015, and resting for a couple of years while central banks elsewhere continuing to build their respective assets with freshly printed capital, announced that US reduction would begin in October ’17, at the rate of $10 billion per month for Q4’17, $20 billion per month in Q1’18, $30 billion monthly in Q2’18, $40B monthly in Q3’18 and $50 B monthly in Q4’18. At the same time, the Fed funds rate is expected to increase by 25 basis points somewhere between two and four times in calendar ’18. With a new Fed Chairman, it seems like these changes are “baked in the cake”, “data dependent”, as always, but unlikely to be adjusted. Our caveat: the policy won’t change until it does, and we believe it will, but not until capital markets are in serious disarray.
Recall also that other central banks are trying to “normalize” their balance sheets. The total result is that among the four major Central Banks (US, Europe, Japan, and China) the potential change from the fourth quarter of ’17 until Q4’18 will be about $1 trillion annualized. ($600B annualized in the US, plus $400 B or more annualized elsewhere). Parenthetically, about 20% (approaching $4 trillion) of the outstanding debt of the US matures within twelve months, and the current operating deficits ($1 trillion in the US, plus deficits in Europe, Japan and China has to be financed as well. The question then becomes whether worldwide liquidity, and presumably better economies, provide enough liquidity to absorb the enormous debt issuance. WE DON’T (and can’t) KNOW. However, the charts below seem to provide a clue.
Chart #1 shows the change in the yield of the two-year treasury note. A chart of the five year would look the same. The ten year has not changed as much, no doubt because a majority of the US debt matures within five years, and with new financing is done on a short-term basis, there is not the overhang on the longer-term maturities. Of course, the rollover of the shorter-term paper immediately increases the interest expense within the US budget. Four trillion dollars financed higher by 100 bp (1%), increases the debt expense by $40 billion. Chart # 2 shows the S&P 500 index. Chart # 3 shows the performance of the DXY, which represents the US Dollar versus a trade weighted basket of other currencies. The point here is that these dramatic changes in the capital and currency markets started, virtually to the day, when the Fed started to normalize its balance sheet in October. Since the rate of normalization was only $10 billion per month in Q4’17, and will accelerate to $50 billion per month by Q4’18, it seems to be at least a possibility that volatility will continue and the bias will be to the downside for stocks, bonds, and the US dollar as well.
Relative to the unexpected weakness in the US dollar while interest rates are ratcheting higher, we suspect that the prospect of trillion-dollar deficits as far as the eye can see have become disturbing to currency investors.
It is worth noting that over the last five years, Central Banks (not including the US, which hasn’t changed its 8,400 ton holding since the dollar exchange for gold was terminated in 1971) have bought five times as much gold as they have US Treasuries. It is also noteworthy that the price of gold is up about 5% since September 30, 2017, no doubt as a non-correlated “safe haven”, representing the possibility that higher interest rates are a harbinger of higher inflation and also benefiting from the weakness in the US dollar.