Whether or not the Federal Reserve has the ability or willingness to plug in deleveraging-induced black holes in the financial sector’s balance sheets with printed money is a foregone conclusion at this point. But the real question is whether or not this is priced in. Or rather, whether or not current asset marks are a reflection of that perception of permanent backstopping.
As we enter 2010, the 30yr Tsy bond yields more than 4.5%, the 2s30s curve is at 367bps (up 55% YoY and at thirty-year wides), the United States public debt has surpassed 94% of GDP, and 13% of tax revenues are for servicing debt interest alone. Roll risk is clearly a significant issue at the Treasury, as diminishing tax receipts and weakened foreign reserves drastically damage potential capital inflows, exacerbating decades of fiscal imbalances.
The basis to the structural global imbalances is the American consumer. With freely available credit (thanks to the Federal Reserve) and inflating asset values producing a “wealth effect,” the American consumer levers up household balance sheets by debt-financed consumption. As emerging economies enter international capital and labor markets, American consumption shifts to goods produced for low costs in these emerging economies. This capital flows from the United States to trade surplus nations’ reserves. The emerging economies invest these reserves in dollars and dollar-denominated debt, as the dollar is the most liquid and international reserve currency in the world (with most commodities priced in the currency) and supporting the United States is vital to their exports, their main engine of growth.
However, without the American consumer, these creditor nations are forced to make a secular policy shift and domesticize growth. This implies reserve diversification and lack of net demand for Treasury securities (and possibly a shift to net supply offered). Though the global liquidity & reserve status of the dollar and political & economic leverage held by the United States prevent an all-out creditor nation hyperinflationary exodus from the USD and spiking Tsy yields, a disappearing American consumer prevents creditor nations from continuing the status quo of sovereign consumption financed by foreign capital inflows. Especially when deficit spending is skyrocketing, monetary supply and debts are surging, and both foreign inflows and domestic tax receipts are dwindling.
And the American consumer has hit the debt wall and can no longer lever up to capacitate further foreign capital inflows into Tsys, after experiencing two asset crashes within a decade. The most recent consumer credit figure, a $17.5 decline reported for November 2009, is the largest recorded and represents an 18.5% annualized dropoff in revolving consumer credit. Household deleveraging has come and is here to stay, especially with the spiking unemployment rate.
With the foundation to the creditor nation-financed suppression of bond yields suddenly gone, the Treasury has to look elsewhere for demand, especially down the curve. Thus far it has found a suitable substitute in the Federal Reserve, but monetization causes a bearish reflexive response in the Tsy market, as investors offer supply because of inflationary concerns. Indeed, since Bernanke announced the QE program back in March 2009, the 30yr yield has risen 753bps, or 20%, dramatically increasing funding costs.
Because of the roll risk and the ever-shortening average duration of marketable Tsys, Bernanke’s Fed cannot print money and inject liquidity into perpetuity, ceteris paribus. With the complacency present in the market, and signified by the surge in bond yields since March 2009, increased liquidity will appear unwarranted and will be met with an even greater increase in Tsy rates, and consequently funding costs for the United States.
The market is discounting the credit crisis as a liquidity crisis rather than a solvency crisis. The Fed cannot inject more liquidity into an environment characterized by surging bond yields without causing a positive-feedback creditor exodus hyperinflationary and/or debt default scenario. Any further substantive marginal liquidity will have to be reactionary.
This is a similar dilemma as the Fed faced in mid 2008, when inflationary pressures from rising commodities prices forced hawkish policy, even as a credit crisis stemming from a bursting housing bubble brewed underneath. Eventually, the hawkish actions helped catalyze the bursting of the commodity bubble and inflationary pressures, but at the expense of catalyzing a mean reversion and consequent credit crisis.
Now, the Fed can’t continue or suggest continuing its liquidity injections into perpetuity, as basically every market is discounting a recovery. But if it doesn’t, a massive hidden second wave of deleveraging and market volatility will be unmasked.
Aside from the economic implications of a permanent Bernanke put, there is insufficient political capital for continued injections. Obama’s popularity has dwindled with the dollar’s value, as taxpayers feel the effect of classic CC-PP game theory. Allegations of bank-government collusion and populist anger directed at bankers and politicians are forcing deliberation over exit strategies already.
In addition, further QE (by which I mean another trillion or so, not just a couple more hundred billion in Agency debt purchases) would suggest to the market that the Fed doesn’t believe we are out of this mess yet. That would have drastic effects on bond yields and the USD, and though equities may remain stagnant or even rally, their returns wouldn’t come close to offsetting the dollar’s decline.
The Fed is caught in a trap where it must have its attempts at liquidity injection proven insufficient, to which there will be a massive influx of capital into Treasuries, suppressing rates, as well as a rush to liquidity and asset selloff that will replenish the political capital needed for the Federal Reserve, Treasury, & Obama administration to institute new bailout and QE programs.
Only when the imbalances in financial markets, hidden by excess liquidity, finally come to light with a sharp wave of deleveraging and credit crunch, will the reactionary policy that will catalyze a perception of backstop permanence priced in to the market.
Until then, the underlying deleveraging gorilla can and will reclaim hold over price fluctuations, but only when the offsetting QE liquidity dries up. Once the true state of affairs is uncovered, the Fed’s reactionary policy will become a permanent trump card, but only then. At that point, individual sovereign credit risk idiosyncrasies will dictate future market behavior, rather than individual financial sector risks and ability/willingness of respective central banks to backstop losses.
Keep in mind that the already growing perception of globally coordinated debasement and a “race to 0” may cause a “higher low” in risk assets during the next wave of deleveraging.
Deflation first, inflation second. (In the United States.)