US Debt. No Summer of Love…

By Allston Mitchell, September 15, 2011

U.S. National debt clock

U.S. National debt clock

China is wagging its finger at the US for its cavalier attitude to its debt problem, equity investors are piling out as QE2 comes to an end; debt bears are warning of a US bond market meltdown; three rating agencies have now taken aim at the US economy and Congress is playing in the sandbox.

“Sell in May and go away”, by all means, but keep an eye open on your Bloomberg terminal, as this summer may offer some interesting surprises. We may not have to wait until October for a spot of drama.

Goodbye QE2
At the end of June the U.S. Federal Reserve’s “QE2” comes to an end. The Fed will have pumped c$600 billion into Treasury securities during the life of the programme. Ben Bernanke has intimated that there will be no QE3. So what happens now?

It is difficult enough to gauge exactly what effect QE2 has actually had on the US economy – we are being asked to take it as an article of faith that life woud have been much worse without it – and it is equally difficult to gauge what the consequences of the Fed funds drying up will be. The general assumption is that interest rates will see a hike as the Fed intervention has been keeping them under control. There should also be an increase in volatility (which will please traders) as investors get to grips with the short- term future. Equity investors however, seem to know what is going to happen, they are piling out of US equities – conventional wisdom says that both equities and commodities will take a hit. There is a lot of apprehension and not much surety.

One thing is for sure though, the Fed, as a result of its Quantitative Easing, has now become the largest holder of US debt, even overtaking China. The Fed now holds roughly 14% of total outstanding federal debt (debt held by the public). It is now the single-largest creditor of the US government. China now owns Treasuries worth “only” US$1,145bn, which is just under 12%.

China, despite its massive portfolio of Treasury bonds, has reduced its US bond holdings for a fifth month in a row. Its holdings fell to US$1.145tn in March, down US$9.2bn from the previous month and down US$30.4bn, or 2.6%, from last October’s peak of US$1.175tn. China is getting nervous about its holdings and has been telling off the US insisting it put its house in order, even accusing the US Treasury of back door de facto defaulting with its weak dollar policy. China’s confidence in the US economy is wavering.

So that is problem number one. QE2 will be leaving a gap and considerable uncertainty mid summer.

The dollar
The dollar has lost more than 25% against other currencies since the year 2000. It has lost nearly 5% this year alone. The problem is that with interest rates being so low, holding US dollars is not such an attractive proposition. Why not give your appetite for risk free rein in some more dynamic currencies? That is just what investors are doing.

However, for those investors sticking to the US dollar, at what point will they say that the security of a Treasury bond is all very well but if you are hacking away at the value in currency terms I may just high tail it off to invest in some German bonds. Is the US Treasury pushing its luck or presuming too much? The Treasury just has to hope that it gets the timing right and does not have to lower interest rates to fight inflation just when the bond markets and a lackluster economy are calling out for a looser policy. That would be a no-win situation.

So that is problem number two, a dollar which investors may just turn their back on if they are pushed a step too far.

US Debt

There are some very nervous investors out there who are seeing U.S. debt not only as a percentage of GDP ratio (currently 64%), but are adding Medicare and the Fannie and Freddie headaches to the equation, all of which adds up to one big disaster.

Solutions to this have been tried. Over the last few year we have seen the US inject billions into AIG, Fannie Mae and Freddie Mac. The country has been living with the effects of basically zero percent interest rates and a dubious and unquantifiable QE1 and QE2. So what is the remedy, more of the same? Are there more effective solutions? In the meantime more debt issuance is required.

Some people are not waiting for an answer, such as the rating agencies – who have been accused in the past of being a trifle slow and accomodating. The rating agency Fitch said (now the third rating agency to threaten the US with a downgrade) that massively reducing government spending is not the real answer but a rise in the borrowing ceiling most certainly is, despite this being a political nightmare – especially with US presidential elections coming up. Republicans are insisting on deficit cutting measures in return for their voting for an increase in the debt ceiling. Time is not in Congress’s favour though, lawmakers must decide by August 2 of this year to increase the borrowing limit beyond US$14.29 trillion. Republicans are digging in their heels, they have the Tea Partiers breathing down their neck and the Democrats know that this is not the moment to get picky, it is time to rally round and solve the problem. The deficit reduction has to come over time and cannot be a campaign rallying point. The country’s economy has to be fixed. But the bi-partisan spirit is missing. The markets are watching and twitching.

The real question is whether or not the United States will genuinely be able to service this massive debt. Financial analysts are expecting some serious maneuvers to solve the problem in the next 18 months – if only to show that the gravity of the problem has been recognised. This is a critical time for a country that has had a triple-A since 1941. The US has to inspire confidence in its ability to fix the problem.

That is problem number three, a massive deficit that may or may not get serviced but more importantly the question is whether or not Congress has the political will or even the nous to get this problem solved. The pleasures of mud slinging may get the better of them. Have a good summer.

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