The thesis is simple and familiar: the United States is running a fiscal deficit and a current account deficit (i.e. "twin deficits") and relies on domestic and foreign investors to buy US Treasuries.
The bigger the fiscal deficit is the more Treasuries investors - including the Federal Reserve - need to buy. At the same time, the more Treasuries that have to be sold, the highest the interest rate all else equal... until something snaps (or unless an stock market crisis forces the Fed and investors to monetize/park cash in Treasurys).
This was, in a nutshell the grim message from the IMF's latest Fiscal Monitor Report, which warned that the US would be the only country with growing debt levels over the next 5 years.
What the IMF did not elaborate on, however, is that in many countries, such twin deficits have resulted in a debt crisis. So, picking up where the IMF left off, Deutsche Bank conducted an analysis which found that "the deteriorating fiscal and external situation for the United States have increased the probability of a US debt
crisis by 7 percentage points, from a historical average below 9% to a level around 16%." More details:
As shown in Figures 10 and 11 below, the model-implied odds of a crisis are set to tick higher over the next several years as government debt levels increase and the current account deficit grows. Indeed, the probability tends to rise to an abnormally high level outside of recessions. The pre-crisis average was around 9%; the next four years will average a bit more than 15%. This is mostly due to wider fiscal deficits, which we expect to widen to around 5.0% of GDP in each year through 2022. Fiscal expansion will boost growth this year, partially reducing the odds a crisis in the very near-term, but this effect will fade over the forecast horizon as growth slows down to its long-term trend and fiscal deficits remain large.
Deutsche bank's conclusion is troubling: "the model-implied odds of a US debt crisis in the coming years are set to surge to the highest ever non-recessionary level." And, it goes without saying, they may well hit an all time high once the next recession (or depression) hit, some time in the next 12-24 months.
To be sure there are several mitigating factors when it comes to a US debt crisis, chief among which is that the US is the world's reserve currency (for now).
As DB needlessly reminds us, "the US exclusively borrows in its own currency, while the model includes countries that have been exposed by borrowing abroad; the US has scope to raise additional revenues (its overall tax rate of 26% of GDP in 2016 is below the OECD average of 34%); and the US dollar is the de facto global reserve currency."
This last point is significant. Figure 12 shows that almost two thirds of global official reserve assets are held in US dollars. One out of every four dollars lent to the US Treasury comes from the foreign official sector. These institutions need a safe, deep, and liquid place to park their reserves. The appeal of Treasuries is further boosted by the US’s military strength, the nation’s cultural appeal, and strong domestic institutions. There are few alternative to US Treasuries in the size and scope of a safe asset demanded by global investors.
True, but this brings up an interesting, and critical, point, one which Bank of America first raised last week, when it suggested that "The 10Y Treasury Is No Longer A "Safe Asset."
Deutsche Bank echoes this warning, and writes that whereas Treasuries tend to rally in episodes of market stress, even when US economic growth slowed sharply in 2008 or when China devalued its currency and signaled potential selling of its Treasury holdings in 2015, "this is not happening today, which is why investors need to pay attention to whether an EM-style debt crisis is about to play out."
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Which brings us to Deutsche Bank's key point: is the US headed for a debt crisis and where should investors look for early signs of a debt crisis?
As DB macro strategist Quinn Brody writes, crises are usually characterized by a “sudden stop” in financing. And whereas both fiscal and current account deficits require capital inflows, declining foreign demand for Treasury securities might signal imminent pressures. Fortunately, the strategist adds, "no major signs of such stress are currently evident, but investors should continue to monitor Treasury auctions for any signs of declining external demand. This will be particularly important in 2018, since Treasury supply is set to increase sharply and several pillars of demand are likely to soften, see Figures 13 and 14."
As deficits continue to grow further in 2019, auction supply will continue to rise, surpassing $1 trillion this year, and growing substantially in coming years.
So far in 2018 the US Treasury has substantially increased the supply of T-bills - which many have speculated caused the blowout in Libor and LOIS - but later this year the supply of longer-dated government bonds will also increase.
As auctions sizes grow, two key pillars of traditional demand support are fading:
- the Fed is shrinking its balance sheet
- foreign purchases are falling particularly as the ECB ends QE.
These trends are evident in lower bid-to-cover ratios, which have recently reached their lowest levels since the financial crisis, as shown in Figure 16. The same trend is evident across auction tenors.
Meanwhile, the Fed will continue paring back its balance sheet reinvestments this year. At 10-year auctions over the last two years, the Fed has absorbed 7% of bond supply, on average. Steadily declining reinvestments will force Treasury to borrow more from the private sector, increasing auction sizes. Simultaneously, Deutsche Bank finds that the scale of foreigners’ debt purchases at Treasury auctions has dipped to its lowest level since the 2013 taper tantrum (chart below).
This is especially relevant for the US, since foreign purchases of Treasuries are a key avenue of current account deficit financing. Other countries, e.g. Japan, have been able to build up very large stocks of sovereign debt, but they are often financed by domestic savings.
Why is foreign demand for US paper softening? According to the biggest German bank (which itself will need some serious investor demand for its stock in the coming months), it reflects several factors.
- Firstly, the dollar has been weakening substantially over the last 15 months. US policymakers, in a departure from tradition, have used their rhetoric to “talk down” the dollar. To some extent, this reinforces market expectations for further depreciation and makes purchasing unhedged dollar-denominated assets less attractive.
- Secondly, US asset valuations are potentially stretched already. While Deutsche Bank equity strategists, ironically, still anticipate around 13% upside for US equities this year, the bank's credit team and global strategists acknowledge that this is just for window dressing purposes, and admit that "there will be less incremental demand from overseas investors considering valuations are more attractive in Europe and EM."
- Thirdly, as the Fed has continued to hike rates and diverge from other major central banks, hedging costs have become more expensive for foreign investors. As shown in Figure 18, 10-year Treasuries no longer offer a yield pickup for European-based investors on a currency-hedged basis. The same dynamic is true for Japanese-based investors.
In its summary assessment, Deutsche Bank writes that more than anything, the world needs safe, liquid assets. Historically, this need has been filled by Treasuries- and it still is. Demand has thus far been inelastic despite the increase in supply.
In a testament to the towering "safety" of Treasuries, they have rallied for 30 years regardless of events in the equity world, while rates continue to slide lower as the stock of debt continues to expand. But Deutsche's ominous conclusion, one which increasingly more commentators, including Goldman Sachs...
... and the IMF, have been voicing is that "eventually this will become unsustainable."
We cannot say exactly what level of debt (85% of GDP? 100%? 125%?) will prove to be the tipping point, but we do believe that the latest fiscal developments have increased the odds of a crisis.
And so, while the collapse the reserve currency empire remains open-ended, the bank's recommendation is clear: "Investors should continue to monitor Treasury auction developments and will remain alert to any indications of softening demand."
Of course, when this "tipping point" does arrive, it will be too late to make the proverbial "hedging trades." Which might explain not only the recent strength in gold prices, but why after crashing in the start of 2018, the crypto sector is once again soaring, and bitcoin is fast approaching $10,000 once again...