Investors must beware of the fundamental changes going on in the U.S. dollar
16-Jan-2010 •Sanjeev Pandiya
In an earlier background note, I mentioned that the U.S. demand for world savings is falling off a cliff. Their twin deficits, the Fiscal Deficit (FD) and the Current Account Deficit (CAD), which used to be $560 billion + $700 billion = $ 1.2 trillion, has seen the CAD come down by 70 per cent, to $240 billion. If private demand for world savings is reflected in the CAD, while public/government demand is reflected in the FD, then quite obviously, the deleveraging of the U.S. consumer reflected below, would show up in the CAD.
The U.S. trade deficit with China is down by about 14 per cent or $20 billion, compared with one year ago. The nation’s trade deficit with Japan has shrunk by almost 20 per cent, and its deficits with Mexico, Canada and the European Union are down more than 40 per cent, because of the sharp recent appreciation of these currencies. This stems mainly from the staggering collapse in trade. With credit markets frozen and Americans facing the highest unemployment rate in more than 30 years, U.S. imports have dropped precipitously.
In short, the supply of domestic savings has increased, with the Savings Rate near 9 per cent, while demand for overseas savings (as reflected in the CAD) has come down by 70 per cent. Since the government FD is financed by Deficit Financing, there is now almost no U.S. demand for the traditional sources of world savings to fund its erstwhile twin (revenue) deficits, i.e. Japan/China/Asia.
As already pointed out earlier, these countries have seen a drop in their savings (especially in Japan), or are seeing an increase in the domestic demand for savings, i.e. domestically funded investment demand. In short, the imbalances created till 2007 have corrected spectacularly.
This is the story of dollar fundamentals — which way should the the currency be going. With U.S. demand for world savings dropping, the issuance of dollars to overseas investors should be falling; with domestic savings taking their place, U.S. government bonds are being bought back by U.S. investors from the Asians. Hence, there should be lesser dollars available overseas, right? Then why is the dollar depreciating?
Meanwhile, the Fed pumps billions into the banking system @0.25 per cent. But instead of making loans to the private sector, the banks take the money and buy long-dated U.S. government bonds yielding over 4 per cent. Result: banks make money; but there is no corporate lending.
American savings could be quickly replacing Asian savings, but there is an old stock of about $2.6 trillion of U.S. government debt held by Japan/China, which could be pulled out. That would mean rates of 15 per cent to 20 per cent (like in 1987).... It’s a question of who will bridge the gap, if these countries pull out.
The fiscal condition of the U.S. has deteriorated dramatically during the last several years. On the basis of current obligations, the U.S. indebtedness totals only about $12 trillion. But with the present value of future obligations like Social Security and Medicare — for its ageing population — the U.S. indebtedness soars as high as $74 trillion, more than six times its gross domestic product (GDP).
Let me take you through what the bond markets are thinking. But first: think of bond investors as people who finance government deficits; and government deficits are the P&L Accounts of governments, funded by Current Liabilities, i.e. T-bills or long-dated government debt. Hence, bond market pricing depends on two very important factors: the FD (i.e. the deficit in the P&L Account) and the debt:GDP ratio (i.e. the total stock of indebtedness, like the debt:equity ratio of a company). So, just like a banker looks at the profitability of a company, and its debt:equity ratio, a bond investor looks at the same two ratios of a government.
The chart below tracks the federal budgets for both the U.S. and Brazil as a percentage of each country’s GDP. Back in 1998, the U.S. ran a budget surplus, while Brazil was running a deficit equal to 9 per cent of its GDP. But the two nations have traded places now. At last count, the U.S. budget deficit totalled an astounding 9 per cent of its GDP, while Brazil’s deficit totalled only 3.3 per cent.
And yet, the U.S. government pays only 3.28 per cent in interest per year to borrow money for 10 years; while the Brazilian government must pay 5.05 per cent to attract investors to its 10-year bonds. Thus, the yield spread between these two borrowers is 1.77 percentage points. Quite obviously, bond investors should be selling U.S. bonds (putting further pressure on U.S. savers to buy those bonds with their new-found domestic savings) and therefore, U.S. dollars and buying Brazilian Real and then investing it in Brazilian bonds. This will create a self-fulfilling prophecy: the U.S. dollar drops, and the Brazilian investor not only gets higher interest rates, but also an appreciating currency. This creates a ‘feedback loop’, which leads to ‘carry trading’, i.e. non-savers start doing this, accentuating the trend till expectations change. This is what is going on now.
Bond markets price specific bonds relative to other bonds, known as the ‘yield spread’. (A very common yield spread comparison is made relative to Treasury bonds). So, for example, if a certain 10-year bond issued by another government or a company is yielding 5.28 per cent at the same time that the U.S. 10-year note is yielding 3.28 per cent, that bond is said to be trading 200 basis points (i.e. 2%) over Treasuries. The higher the spread over Treasuries, the riskier the debt is perceived to be.
The yields on foreign government bonds have been falling closer to U.S. yields for several years. Are foreign sovereign issuers becoming more credit-worthy, or is the U.S. government becoming less credit-worthy? Or, is it a little bit of both? Remember what I said above: that two important metrics drive this pricing, i.e. the FD and the debt:GDP ratio.
In case of India, our FD is the worst among the BRIC nations (6.8% national, 9.8% including the states), but our debt:GDP ratio is still about 83 per cent, although it is rising. With Government of India debt going at 7 per cent, there is some scope for carry-trading, which tells me that the government should be following an easy money policy till the U.S. stimulus packages work themselves out, or till Indian inflation becomes a bigger scare, which should happen sometime next year.
OECD interest rates are converging toward the U.S. rates. Canadian and French sovereign 10-year interest rates, for example, have been moving closer to the U.S. rates for several years.
This narrowing of yield spreads is not only evident among issuers like Canada and France, but also among emerging market issuers, especially the rapidly emerging market issuers like Brazil. Some investors might infer, therefore, that emerging market bonds are too expensive, relative to Treasuries.
Risk-free Treasury bonds are not as risk-free as they used to be, especially for international bond investors, who deal with currency-adjusted returns. Increasingly, they are driving currency movements; India is, as yet, not too exposed, because foreign institutional investors (FIIs) investments are not freely allowed in Indian government bonds, but through the ECB route and corporate bonds does this money flow into India. This money was the real culprit in the 2008 collapse of the rupee. At the moment, this is the money which will drive rupee appreciation, besides the huge drop in our forex outgo because of the Reliance/ Cairn oilfields, as we turn balance of payments (BoP) surplus next year. As these two factors kick in, the rupee could break all barriers, which is why we should sell at all levels, but not too much at any point in time. It is impossible to predict the exact number at which the rupee will stop, till we get a fix on what is happening to the international bond markets. And the reversal will also come from a bond market collapse, when the fundamental changes going on in the U.S. dollar kick in.
Difficult to predict, yes. But if you are looking at the right places, you will be first off the mark to get out of the way. Not looking is not the answer!