The Federal Reserve, Trump, And $10.5 Trillion In Dollar-Denominated Debt In The World

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Summary

The United States is integrated into world financial markets to the extent that it cannot act independently of what is going on in the rest of the world.

There is $10.5 trillion in dollar-denominated debt held outside the United States, debt that is very sensitive and can move very quickly if investors want to move it.

Some foreign funds left the US after the November election, so the Fed and the federal government must be careful what it does so as to not scare more away.

Over the past year or so, I have been writing more and more about the amount of international funds that have been placed in US bonds, especially in US Treasuries.

As I have explained, these funds have tended to be "risk averse" monies that have sought a "safe haven" in the United States financial markets.

Where these flows of funds have tended to show up has been in the yields on the US Treasury Inflation Protected securities (OTC:TIPS). When the yields on TIPs have dropped significantly, especially into negative territory, this has occurred as many of these "risk averse" funds have moved into the United States.

At times when some of these monies began to flow back out of the US, the yields on the TIPs began to rise.

A noted example of this last type of behavior occurred last November as the Trump election became a reality. Just before the election, the yield on the 5-year TIPs was about below a negative 40 basis points and the yield on the 10-year TIPs was around 7 basis points.

Immediately after the Trump victory in the election, the yield on the 5-year TIPs rose to a range of in the negative 20 basis point to 15 basis point level and the yield on the 10-year TIPs rose to around 35 basis points.

As more information on international money flows became available, we learned that funds flowed out of the United States after the Trump victory and this appeared to be causing the rise in the inflation protected rates.

By the middle of December the yield on the 5-year TIPs became positive, reaching the 15 basis point level while the yield on the 10-year reached 70 basis points.

Whereas this has backed off a little, there is still much concern over how these risk averse funds will perform over the next year or so.

Mark Whitehouse of Bloomberg View has just written a concise piece titled "The Fed's Global Dollar Problem."

"The Federal Reserve might be doing the right thing for the U.S. economy by moving to bring interest rates back up to normal. But for foreign companies and governments that have borrowed trillions of U.S. dollars, the adjustment could be painful."

According to the Bank for International Settlements there was $10.5 trillion in dollar-dominated US debt held outside of the United States. This figure is more that three times the amount of debt held outside the US in September 2004.

Whitehouse notes that the duration of this debt is close to its highest point in two decades. That is, it is more sensitive to movements in interest rates now than it has been over the past twenty years or so.

And, the Federal Reserve, which just raised its policy rate last Wednesday, is scheduled to raise this rate two more times this year…and several more times in the next year or two.

Mr. Whitehouse then presents figures produced by Bank of America Merrill Lynch that estimates that a one percentage point change in interest rates could wipe out around $500 billion in bond value.

"The broader effect of such losses will depend to a large extent on where the risks are concentrated. If they're spread out among a lot of investors with solid finances, it could be no big deal. If they're focused on thinly capitalized banks, it could be more damaging. In any case, the repercussions will likely come back and hit markets and growth in the U.S. as well."

The bottom line to this story is that US financial markets are closely integrated with world financial markets and this means that what ever the Federal Reserve does is going to have vast international implications.

Whether officials at the Federal Reserve like it or not and whether members of the US Congress like it or not, the Fed must take into account its actions and their effects on world markets in addition to the two goals that Congress has given the Fed, high rates of employment and low rates of inflation, when deciding upon monetary policy.

But, in addition, the US Congress and the President must take these world effects into consideration when it builds a fiscal policy. That is, the US economy is so integrated into the world right now and plays such a leading role in international finance, that what is happening in global markets cannot be ignored in the creation of either monetary or fiscal policy.

With $10.5 trillion in US dollar-denominated debt out there in the world, and, given that a lot of these monies are very policy sensitive, movements in and out of this debt can show up quickly in the markets.

If we are looking for a "leading indicator" of what the foreign money is doing, I suggest that one keeps their eyes on the TIPs yields. If one sees these yields rising significantly then one needs to examine what is going on politically to determine how government actions are impacting international money flows. The rising rates would reflect a lack of confidence in government policies that leads to an outflow of funds.

Lower yields on the TIPs would indicate just the opposite, that the market was gaining some confidence in the government policies.

Right now, it can be argued that a lot of these funds are very sensitive to the current political environment in the United States and are ready to move if they don't like what they see.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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