Ashmore Investment Management

Originally published in the June 2011 issue

US treasury securities have rallied since the end of April. This seems a clear indication that the market completely shrugs off the possibility of a hiccup in the short term, let alone over the medium in light of the adverse US fiscal position. The US Federal Government has tripled the dollar amount of debt outstanding since 2000, the last time the federal budget was in surplus excluding social security.

Federal Reserve chairman Ben Bernanke recently reiterated that the fiscal situation is the US’ most urgent economic policy problem. The combination of high levels of indebtedness, the scheduled end of the Fed’s policy of quantitative easing and increasing weariness by foreign central banks to increase their exposure to US government risk should eventually result in support being withdrawn. The Greek crisis has illustrated that the market is prone to disregarding underlying and impending economic fundamentals. While materialisation of a Greek-style crisis in the US is remote, the probability is significantly greater than zero.

The US fiscal outlook remains highly uncertain. President Barak Obama presented his latest medium-term fiscal adjustment programme on 13th April. The scheduled end of QE and possibly less international reserve accumulation by central banks naturally begs the question of who will be buying all those US treasury securities. President Obama’s latest proposal aims to achieve a reduction of the federal deficit to 2.5% of GDP by 2015 from the currently projected 9.5%.

Based on the projections by the Congressional Budget Office of President Obama’s current 2012 budget, this would still amount to substantial net financing needs and hence additional net issuance of treasury securities through 2015 well in excess of pre-crisis levels. Alternative budget proposals may alter the pace of net debt issuance by bringing forward additional net expenditure adjustments.

However,the medium-term implementation of any plan remains highly uncertain. It seems therefore safe to assume projected sustained high levels of net issuance over the medium term even under the latest Obama proposal. This poses an actual permanent negative supply shock for treasuries.

The financial and economic crisis for the US is of course above all a debt crisis. High overall levels of indebtedness of households, business and above all the Federal Government will make financing more difficult. Total so-called credit market debt in the US is $36.3 trillion (248% of GDP) of which households owe $13.3 trillion, businesses $11.1 trillion and the Federal Government $9.3 trillion (state and local governments owe an additional $2.5 trillion). The level of debt increased.1 (See Fig. 1) from 2000 by 65%of GDP and can almost entirely be attributed to increased debt incurred by household mortgages (21%) and the Federal Government (31%).

The level of indebtedness is expected to constrain the capacity to absorb continuous increases in Federal Government debt. The largest holders of treasury securities are foreigners (rest of the world), in particular foreign official institutions, the Fed and households.2 The largest increase in net holdings of treasuries was incurred by foreigners and households. The annual net increases of treasury holdings in 2008-10 of US$1.4 trillion are significantly larger than average annual net purchases in 2000-07 of US$0.2 trillion. Foreign central banks and households, including non-profit organisations and hedge funds, have been the largest purchasers of treasuries in 2008-10 (See Fig.2). Households have maintained their treasury holdings broadly constant since Q2 2010.

The Fed increased its treasuries holdings significantly from 2008 onwards with the start of the treasury purchase programme in March 2009 (treasury LSAP). The Fed announced additional purchases of longer-dated treasury securities of US$600 billion in November 2010 to be conducted through June 2011 (QE2). The Fed purchased $0.5 trillion of treasury securities through end-2010 and $0.9 trillion through end-March 2011 conducting average monthly purchases from November 2010 of $0.1 trillion. The Fed’s purchases of treasury securities between November 2010 and end-March 2011 were US$0.48 trillion compared with an increase in treasury debt held by the public of $0.58 trillion over the same period, that is, the Fed purchased more than 80% of the net increase of treasury securities outstanding.

US treasury security prices reflect the Federal Government’s capacity to pay in nominal terms and some liquidity preference. The former is normally not called into question (Standard and Poor’s recent outlook downgrade for the US was plainly ignored). However, the fact that Federal Government debt has increased so dramatically, that the budget deficit is unsustainable at current levels, and that there is increasing polarisation of views among members of Congress as to how to tackle the deficit should alter the Federal Government’s capacity to pay. All else being equal, it can only mean that the government payment capacity has diminished in absolute terms (which is not meant to imply that the US government is insolvent).

The increasing dependence on foreign financing of the deficit also indicates that US policies will have to take increasingly into account entities that are not part of the domestic policy environment possibly complicating main financing parameters.

The US federal debt ceiling of $14.294 trillion was hit in mid-May. While the Treasury will possibly manage to operate and meet payments due for some time by using available cash resources and shifting some of the treasury securities auction schedules, eventually the debt ceiling will have to be raised. The probability of the Federal Government not to meet its obligations due to the debt ceiling is very small (and a technical constraint above all). However, the fact that the Federal Government’s ability to meet its payment obligations depends so immediately on an act of Congress is itself naturally problematic. It seems unlikely that any other country in the world could get away with such an arrangement without exhibiting some increase in financing costs.

Current treasury prices seem to bear no relation to the fiscal outlook of the US. However, prices may also be a reflection of important market segmentation. Many investors who are simply not willing to hold treasuries at current prices may have exited the market entirely making current prices highly susceptible to conviction reversals. Fed purchases must also constitute a significant price distortion. The remaining holders are fairly concentrated converts including the Fed, households and foreign central banks. Central bank treasury purchases, as approximated by Fed custody data, indicate that quarterly net holdings of treasury securities are up since mid-April but average quarterly net increases year-to-date are still only a third compared with 2008-10. Central banks may decide to simply continue to extend credit to the US but may also seek to recalibrate their exposure (recent gold purchases are such, albeit mostly futile attempts given the amount of gold available).

The combination of reduced debt payment capacity (debt level), shaky payment willingness (Congress), limited domestic absorption capacity (households need to reduce debt) and tempered external demand (central banks buy less) should lead to lower prices of US government securities. Similarly on the economic outlook, a prolongation of existing economic conditions is not sustainable as public economic policies have to adjust, higher inflation would erode the value of debt, a period of prolonged deflation would markedly deteriorate the Federal Government’s debt payment capacity. The probability of a significant upward adjustment of treasury yields therefore seems the outcome most consistent with economic fundamentals. A continuation of QE may mitigate but cannot suspend those fundamentals. The market should be wary of not attempting to defy economic fundamentals for too long.

(1) US sectors hold significant assets against their debt and continue to exhibit high positive net worth. However, the net worth will be determined in large part by price developments in the housing sector.

(2) Holdings of US treasury securities by official and private entities are difficult to assess as transactions among foreigners are not recorded by U.S. statistics.