The sharp spike in bond yields we saw today - presumably as a result of the Fed's comments on the duration of continued accommodative policy - tends to bring added emphasis to the subject matter of this article. I haven't had much to say in recent weeks as the "fiscal cliff" has been the driver in stock market pricing and I had already written on the matter in numerous articles spanning about 4 months.
Now that the "fiscal cliff" is behind us it is likely the more onerous and contentious matter of dealing with the debt ceiling will be the driving force in market action for the next several weeks. We all know the nature of the problem - can we continue the policy of borrow and spend or should we get serious about the debt and deficit?
I am convinced that no easy answer exists for Congress on this matter. It occurred to me that the "Triffin dilemma" is worthy of some consideration and gives us a perspective that is seldom considered when pondering the matter of how to get our economy off life support and operating on its own power. Robert Triffin's views concerning the dilemma a reserve currency nation is confronted with during times where an expansive monetary policy is required on the domestic front seem particularly appropriate for our times.
First a little background - Robert Triffin was a Belgian born and Harvard educated economist. He held positions with the Federal Reserve and the IMF and was a professor of economics at Yale. His most notable claim to fame was correctly defining the inherent flaws in a sovereign nation's currency becoming a global reserve currency.
Until 1971, when President Nixon was finally forced to abandon the Bretton Woods system, the United States pledge to convert dollars to gold resulted in more dollars being held outside the US than the US had in gold based on the gold to dollar fix. The result of the demand for dollars produced a continuously expanding current account deficit in the balance of payments.
Triffin noted that the US had to run huge balance of payments deficits to supply the rest of the world with dollars. Triffin predicted that confidence in the dollar and global liquidity were not both simultaneously achievable. Keynes had broached the subject in 1944 regarding his concern for out of control balance of payments deficits. Triffin more clearly articulated the problem and as it turned out both were right.
As I noted above the situation in 1971 was that large dollar holdings created a situation where a run on the bank and a demand for redemption in gold would simply deplete the US gold reserves and leave others holding the bag. Huge foreign exchange reserves had become a serious problem.
Although the US no longer guarantees gold in exchange for the US dollar, the US dollar still remains the most widely held reserve currency in the world. The demand for the US dollar in recent years has spiked as the following chart reflects:
Triffin noted that the benefits of being a reserve currency allowed the US to borrow at very affordable rates. He also noted that a conflict existed between meeting the needs of the global economy for liquidity could easily work to the detriment of the US in times when a policy of monetary expansion was the appropriate course to follow domestically.
The "Triffin dilemma" is another in a long list of "catch - 22" dilemmas that threaten the global economy and not one that gets a lot of attention. At the onset of the recession foreign exchange dollar reserves spiked higher as the chart above reflects.
The sharp spike in foreign exchange reserves correlates well with the US need to provide fiscal stimulus for the domestic economy. The fact that the US was able to borrow to meet the needs of fiscal stimulus to bolster the domestic economy and to do so at affordable rates has allowed the US to keep the domestic economy afloat for the last several years.
The situation we are in today presents two very conflicting goals:
- To retain the dollar's credibility as a reserve currency it necessarily must hold value relative to other currencies which allows the US to continue to borrow and finance fiscal stimulus policy.
- To stimulate the domestic economy the desired objective would be to devalue the dollar and in so doing drive domestic spending and increase export demand.
Fed policy to expand the money supply with a series of quantitative easing initiatives in recent years is designed to accomplish the latter objective - an expansion of the dollar and a commensurate drop in its value. Fed policy has not been very effective at achieving that end to date. There is no question the Fed has moved to inject massive liquidity into the system and that policy is designed to expand dollars and in so doing drive the dollar lower.
To date the fact that the Fed's policy has failed is both good and bad. It is good in that the dollar has remained relatively strong and therefore remains in demand allowing the US government the ability to borrow at affordable rates and in large quantities. It is bad in that it has failed to significantly devalue the dollar and in so doing stimulate GDP growth in the US.
On the domestic front
The upcoming debate on the debt ceiling is much more contentious and threatening to the economy than many seem willing to admit. The idea that the Federal Reserve can just keep on printing until we finally solve the problem is simply not true. The issue really isn't even a matter of the Fed policy in the first place. The mechanism for moving new money into the economy is a function of private sector bank lending, not quantitative easing.
Quantitative easing means that the Fed purchases securities from private sector banks with cash. The impact to the banks' balance sheet is a debit to cash and a credit to the appropriate securities account. This results in a higher cash balance on the banks books and therefore an increase in bank reserves. The increase in bank reserves - cash - allows the private sector banks to make more loans and that does in fact have an inflationary effect as it does expand M2 supply but only when the cash is used to make loans.
Let's look at another chart - excess bank reserves:
Fed balance sheet expansions since the Great Recession have been in the neighborhood of $3 trillion to date. That money found its way onto bank balance sheets through quantitative easing initiatives. What's relevant though is that approximately half of that money is locked up in excess reserves as the above chart reflects. It is only when the bank loans that money out that new money is really created. A loan transaction moves a portion of those excess reserves from the banks' cash account to a depositor account. That is how M2 is really expanded - not the function of the easing policy itself.
Although quantitative easing does increase M2 by the amount of the Fed cash injection the process in and of itself does nothing to expand M2 within the economy. The simple truth is that M2 that remains locked up in excess reserves never finds its way into the broader economy. Keynes defined the problem as the "liquidity trap."
There are a couple of other charts we can look at to drive home the point. The first chart is the amount of loans in the private sector:
This chart shows a relatively flat line growth in private sector loans since the recession and offers confirmation that the private sector banking system is simply not getting with the program. From a domestic perspective what we would like to see is a sharp rise in private sector lending and a sharp drop in excess reserves. That would mean real M2 growth as each new loan works to expand M2 beyond the level of the quantitative easing injections and more importantly moves money into a depositors account where it can be used to drive GDP.
The second chart is the velocity of M2:
The M2 velocity is at a 50 year low and validates my point that QE is not working to expand money supply in the broad economy or produce GDP growth. Money velocity is determined by dividing total M2 into GDP. The reason the money velocity is so low is that the excess reserve portion of M2 is locked up and doing virtually nothing to drive GDP. Excess reserves are included in M2 numbers meaning that the higher M2, when divided into the GDP number, produces a lower money velocity number.
The reality is that real M2 - at least as it relates to GDP growth - must be reduced by the excess reserve portion of M2. If that were done we would see a much higher money velocity number. In other words, the amount of M2 that is actually in circulation is much lower than the actual M2 number suggests and the take away here is that Fed policy has done little in a real sense although a misunderstanding of this dynamic has done much to inflate asset values including equities and precious metals.
On the global front
The fact that Fed efforts to stimulate the economy through QE have failed means that dollar supply in the domestic economy has not grown significantly and therefore the dollar has remained relatively stable during this period. That of course is what we want to happen from a global perspective. A strong and stable dollar is what is needed from a reserve currency perspective. It is also what has permitted us to borrow trillions of dollars at very low rates.
Of course, as Triffin correctly noted the two objectives create a paradox. If Fed policy works to devalue the dollar which is the intent with QE initiatives, it necessarily makes the dollar's value as a reserve currency less attractive. From a reserve currency perspective, a lower dollar means the bonds held by sovereign countries to provide liquidity and a safe store of value become less valuable.
The impact of a domestic policy that expands dollars and fuels M2 growth and a lower dollar would do a lot to help the domestic economy from the standpoint of making goods and services more attractive. Holding the dollar which is seen as losing value would be inflationary and that would drive prices higher resulting in increased GDP. It would also make US goods and services more attractive and result in an upward shift in exports - again a good thing for the domestic economy.
The downside to this would be that the US dollar could lose its status as the most attractive reserve currency. The result would be that bond prices would move lower and interest rates higher as those countries holding dollars and dollar denominated securities moved to dispose of them due to the anticipated loss in value of the US dollar relative to their own domestic currency.
As one can see from the above discussion monetary policy success on the domestic front will result in failure on the global front in that if the Fed policy to expand M2 actually takes hold and banks begin to lend we will see a loss in the value of the dollar. As this situation begins to accelerate and the dollar continues to fall those holding US dollar denominated bonds will react by selling them which will drive the interest rates on those bonds higher.
What can we expect going forward?
If we achieve our desired goal from a domestic perspective - M2 expansion and inflation - we will likely end up driving bond yields higher as the dollars value loss makes the dollar as a reserve currency much less attractive. It is honestly another instance of we are "damned if we do and damned if we don't" situation and the dynamic in play here is the "Triffin dilemma."
We are an economy that has been on life support for the last several years and only through fiscal stimulus have we been able to stay in positive territory on GDP. We are now being forced to reckon with the fact that we can no longer sustain these massive deficits.
Assuming we insist on continuing with the borrow and spend policy of the last several years there is little doubt the markets will force our hand with sharply higher interest rates at some point. As I write this I am watching the 10 year move from 1.84 to 1.91. I am also watching the euro dollar move from $1.33 to $1.3050 in just 2 trading sessions. These are pretty dramatic moves and partially explained by the Fed's announcement that they may discontinue QE3 in 2013.
The stock market remains complacent as usual though - down just 12 points on the Dow (DIA) at the moment - but one wonders how long this might last. Alan Greenspan made the comment the other day that we were not going to get out of this mess without pain and I agree.
The inconvenient truth is that we are probably at a point where Congress must get serious about the debt and deficit or the markets will force them to do so. At the present time we are in the $16 trillion range on debt and based on the Congressional move to simply ignore the debt and deficit with its latest version of "kick the can" fiscal policy we will likely increase that number to in excess of $17 trillion before the end of 2013.
Consider that if carry costs were to go to 4% our debt service alone would represent $680 billion annually and 4% is easily within the bounds of what would be reasonable. As that relates to investors there is really no safe haven here. If we tackle the debt and deficit we all know we will contract the economy and move into recession. If we don't do so willingly I suggest the markets will force this outcome on us with sharply higher interest rates.
Additionally, a sharp spike higher in interest rates will not collapse the dollar as many seem to think. What it will do is force both the public and private sector to deleverage as carry costs become prohibitive. This deleveraging process will shrink M2 rapidly and drive the dollar higher.
We got a small taste of that today as bond prices reacted to the Fed's comments on the duration of QE. As bond yields climbed so did the dollar. My guess is this trend is likely to continue on its own without help from the Fed as the problem of continued deficit spending is taken up within the context of the debt ceiling debate.
I will leave you with this closing thought - the 10 year is up 7 points and the 30 year is up 8 points today and the euro is off 2 ½ cents since yesterday's highs. These market moves are very dramatic and I think they inform us of things to come in the very near future. For those who have forgotten I think it is worth taking a look at what happened to the stock market in August of 2011 when Congress last tackled the debt ceiling issue.
Additional disclosure: I am short a group of tech stocks, fianncial stocks and crude oil. I am long the VIX.