Build It and They Will Come; Sell it and It will be Bought

Stacks of dollar bills propped up to form a financial maze

The US is undertaking a great experiment.  What happens when a large serving of fiscal stimulus is provided to an economy that as already growing above trend, with nearly full employment and price pressures near target? 

Judging from the recent string of data, including Q1 GDP, the effects of the tax cuts are not yet evident.  Yet, today’s refunding announcement indicates the bill is coming due.  As it did earlier, the US Treasury is increasing the size of each coupon, including the floating rate note offerings, in the coming months.  The market barely responded to the announcement.

Treasury Secretary Mnuchin is correct.  The dollar bond market in general and the US Treasury market is deep and broad.  The new supply is relatively small compared to the amount outstanding.  In addition, the primary dealer system seems to nearly preclude a failed auction, i.e., one in which there are not sufficient buyers to absorb the amount that was being sold and happens on occasion in Europe, for example.

The US will sell the debt.  The question is who and at what price.  Often in recent months, the primary dealers had to absorb a greater share of the supply.  This risks the need to mark down their inventory to move it.  Due in part to hedging costs, the conviction that US rates were headed higher, and the heavy US dollar, foreign investors did not appear to be significant buyers.

Yields have risen in absolute terms and relative to many other countries. Some Japanese insurance companies have talked about boosting their unhedged allocation to the US at the start of the new fiscal year.   Consider the yield differential between the June 2019 Eurodollar and June 2019 Euribor is 300 bp in the US favor.

The debt will be bought and likely without much fanfare this year.  The number of negative yielding bonds is actually higher now than it was at the end of last year.  That alone suggests a potential source of demand.  The failure of US retail interest rates, like passbook savings and small CDs, to rise may be underpinning the household appetite for fixed income funds.  Financial institutions also appear to be boosting their holdings.

The Federal Reserve did not re-invest $30 bln of maturing bonds in Q4 17 and $60 bln in Q1 18.  It will not re-invest $90 bln in Q2 (and $120 bln in Q3 before reaching the terminal speed of $150 bln in Q4).   Beginning the eighth month of Operation Unwind and there have been no hiccups to date.   However, the lifting of its bid will increase the amount of supply that much be absorbed.

The US recorded a $600 bln deficit in the first half of the first year.  For every dollar increase in revenue, there was a three dollar increase in spending.  The deficit is projected to be a little more than $800 bln after a $665 deficit in FY17.

The US borrowed $488 bln in Q1, which was about 10% more than anticipated.  Much of the issuance was in T-bills after the debt ceiling was lifted.  With today’s refunding announcement, Treasury indicated that it would introduce a new two-month T-bill shortly.  This innovation is nearly the exact opposite of a super-long maturity advocated by some in the Treasury Dept last year.

Investors have a good idea of how the US experiment of providing a large dollop of fiscal stimulus when an economy is already expanding near capacity.  By definition, it will boost the amount of debt that must be sold.  It will likely generate more price pressures.  Some of the stimulus will leak from the domestic economy through imports.  This will likely result in a larger current account deficit.

Many observers conclude that the experiment will result in a weaker dollar.  The “twin deficit” problem was cited as an explanation of the dollar’s poor performance in 2017 and into this year.  This strikes us as too linear a view of the relationship between these economic variables.

Consider that the twin deficits of the first part of the 1980s coincided with widening interest rate differentials and dramatic rise in the dollar.  Although the greenback appears to have peaked in early 1985, the G7 was not convinced and organized a coordinated effort to drive it lower, sparking a ten-year bear market for the dollar.

The Reagan-Volcker policy mix of easy fiscal and tighter monetary policies is being duplicated by the Trump-Powell policy mix.  The decades-long decline in US Treasury yields began as fiscal policy as expanded in the early 1980s by tax cuts and spending increase.  Twin deficits may be perfectly consistent with a rising dollar in the beginning but may become less so as conditions change.