If the day comes when the U.S. Treasury bond auction fails, it will be too late to react. With some help from the mass media, the situation is likely to get very ugly. Markets move faster than ever and once a tipping point is reached, you’ll be like every other sheep at the slaughterhouse. Seeing the signals and preparing for this potential calamity may end up being the next major investing opportunity or wealth destructive event of our lives.
Because the magnitude of its potential impact is so great (some say 50% devaluation of the USD and/or interest rates in the high teens), anyone with significant USD denominated savings should answer the key questions for themselves - even if it is simply to dispel the fear the possibility creates. At what point will the U.S. government run out of debt capacity? What are the factors that tell us when this is likely to occur? And, what is the chain reaction that follows?
To begin to answer these questions, I’ve attempted to map out the cause and effect flows that would lead to a tipping point in Treasuries. The chart below starts to identify and quantify (where possible) forces and events that can lead to a tipping point. So many different factoids are thrown around on this topic that without some framework to evaluate the issue, it is easy to get confused. This is my effort. I hope to improve it over time – feedback and facts are welcome.
The left side of the flows shows the seemingly unstoppable forces leading to substantial US government debt and continued funding of deficit spending through the sale of Treasury bonds. US leaders have clearly articulated the path they will take. Like any good democracy, it reflects the same debt bloated path its citizens have taken over the past several decades. The government will spend whatever is needed to attempt to prevent a depression and restart growth.
Until that is accomplished, US leaders aren’t going to protect against the potential pain this over leverage is likely to create. Their logic is that the spending will allow the US to grow its way out of this mess or at least ration the pain over time. What they are saying is essentially, why worry about treating your cancer, if you’ve just been shot and are bleeding to death. Besides, inflation down the road will lessen the pain of debt repayment in the long run anyway.
US public debt is now projected to reach over 80% of GDP in the near term. This excludes the huge entitlement commitments which are projected to grow dramatically in the coming decade if aggressive changes are not made. I’ve seen numbers for that liability ranging from $20-40T. The chance of the US generating fiscal surpluses to start paying down this debt, let alone not adding to the debt, is remote. The current budget proposes deficits of $1-2T per year into the foreseeable future and our democracy is incapable of inflicting the kind of excruciating pain it would cause to actually reverse this.
On the other side are the buyers of US debt. They are the ultimate deciders of US debt capacity and will be responsible for triggering a tipping point. Foreign holders represent about 55% of the outstanding US government debt. The Chinese alone hold about $750B or 15%. Their influence dramatically increased over the last year as they purchased almost 40% of the debt issued by the US that was purchased by foreign holders. Japan is the second largest holder with about $640B. Because of the concentration of holders of US debt, either one of these buyers can upend the Treasury market by halting the purchase of new bonds or trying to sell their existing holdings.
Understanding the economic, political and other forces impacting the foreign Treasury buyers decision (in particular the Chinese) to continue to hold and buy Treasuries seems to be the most critical part of determining where the tipping point may occur.
There are a number of factors affecting the Chinese decision. First is the question of how much debt the US is capable of supporting, given its GDP, before significant interest rate increases or devaluation would be required. What level is too high 80%, 100%, 120% of GDP? With Entitlement commitments, the US is already 3-4 times higher than these percentages. Some economists argue that the US could support well over 100% levels. They point out that some European countries like Italy have functioned at these high levels as well as Japan. At the deepest point in the Great Depression , US public debt to GDP reached 185%. Conversely, Ireland recently lost its AAA rating when it forecast debt levels in 2010 at 80% of their GDP.
With all the comments from the Chinese, it may be that we have already passed the level and it is only other constraints preventing them from walking away. Recent moves by the Chinese to shorten up the maturities on their Treasury portfolio have heightened this exact concern.
There are important constraints preventing China from abandoning the US Treasury even if they seriously question US credit worthiness. Many experts claim that China is too dependent on exporting to the US and cannot risk damaging that export market. China’s exports represent about 40% of its $3.4T economy with the US representing about 1/4 of that 40% or roughly 10% of their economy. The Chinese are taking aggressive steps to reduce their dependence on exports in general and US exports in particular. The $600B stimulus (which is almost 2.5 times the size of the US $850B stimulus relative to our respective GDPs) and their substantial efforts to develop Latin, Indian and African export markets are clear signs that their dependence on US exports will continue to decline. Recent reports indicate that China expects exports to fall to less than 30% of GDP within the next several years alone. The power of this constraint is waning greatly.
Another constraint on China is the use of the USD as the international currency for denominating commodity prices and as a ‘safe place’ to invest its significant reserves. Long term, the Chinese would like to remove this constraint by establishing an international currency. They repeated their desire to establish an international currency recently before the G20 meetings in London. As the US executes a policy of printing money to fund its huge deficits, the Chinese proposal will become more and more attractive to many of the larger economies of the world (in particular the Germans and Japanese who depend greatly on exports).
In addition to the risk of the Chinese walking away from US Treasuries, remember that significant changes in other critical buyers of US Treasuries could also lead to a tipping point. The recent commitment by the US to purchase 50B GBP, 80B Euros and 10T Yen may be an insurance policy they have created to provide these countries an ability to buy US Treasuries if the Chinese balk. The closer we get to the tipping point, the smaller the change required to make it happen.
The arrows leading out from the tipping point in the center to the blue boxes show the three primary levers the US has to respond. First, the Treasury can crank up rates to attract more buyers. Second, the Fed can step in and buy the bonds – effectively printing money. Third, the US government can cut spending. It’s hard to imagine any meaningful use of #3, so a combination of #1 and #2 are what we can look for.
For the Fed to increase rates, they must go directly against their basic plan of trying to stimulate growth. They also must be aware of the significant costs is adds to US debt service (something like $50B per year per percentage point). This means printing money is the only remaining option. The Fed is already executing a plan to buy $300B of Treasuries as a warm-up. Their stated policy is to continue to keep rates low to stimulate growth. They have been able to do this so far because of the strong demand for the US dollar due to its relative safety versus other currencies around the world at this time. If that psychology breaks, rates will have to move up to continue to attract Treasury buyers – another important factor to watch.
I don’t pretend to be an economist, but I feel forced to try to objectively make sense of this because of the huge potential risks and opportunities the scenario creates. It seems to me that, like many potential crises, people are not allowing themselves to accept the facts because of the magnitude of the consequences. I hope someone can give me the facts to make this go away. Until then, my plan is to continue to track the signals indicating when and where a tipping point may be reached. Stay tuned.
Disclosures: Author owns TBT