Once again, the dollar is being “spurned”, says Lex in the Financial Times. As bullishness has spread, the ‘safe haven’ currency is on the ropes.
The trade-weighted dollar index has set a new low for the year and has fallen by 11% since stockmarkets took off in March. More recently, another factor has begun to weigh on the greenback, says a Bank of America-Merrill Lynch research report: “the long-term sustainability of US public finances”.
This has also been seen in the recent jump in US Treasury yields (reflecting slumping prices for American government debt). The yield on the ten-year Treasury bond has soared from just over 2% to 3.7% in a mere five months, and has gained almost 0.5% in a fortnight.
Some of this increase is due to investors “switching back into shares” on hopes that the global recession might end next year, says Buttonwood in The Economist, while fears over deflation have eased.
US debt is unsustainable
But the issue currently in the spotlight is that a “government cannot go round dropping the odd trillion dollars and expect no one to notice”, as Lex puts it. The US budget deficit will be 13% of GDP this year, or around $1.84trn.
Next year, it is expected to be $1.4trn, and by 2019, a further $10trn will need to be borrowed, according to the Congressional Budget Office.
And that’s somewhat generously assuming that growth will be 4% a year over the next decade. With overall debt of around $21trn in 2019 (including Social Security costs), annual interest payments alone would exceed $1trn, says John Mauldin on Investorsinsight.com. The Government Accountability Office says that “the long-term fiscal outlook is unsustainable”.
The return of inflation
It’s not just the sheer size of the deficit – $2trn in debt is set to be issued this year alone – that’s causing jitters. Fears over future inflation are mounting as markets have realised that “it will not be easy for any future government to drain the enormous amount of emergency liquidity that is being pumped into the system”, says Mohamed El-Erian of Pimco in The Sunday Telegraph.
It’s always hard to gauge when economies are at a turning point, so authorities tend to “overstay their presence in emergency mode”. Meanwhile, the Fed looks set to step up its quantitative easing (QE: buying bonds with printed money), as so far this has had scant impact on bond yields. Indeed, rising bond yields have boosted mortgage rates, putting a further brake on the housing market and the economy. But beefing up QE may only heighten fears of inflation.
A dollar slump, or orderly decline?
So the worry, says Mauldin, is that the deficits can only be financed at considerably higher interest rates, implying lower bond prices; or by printing money, with a jump in inflation also implying lower bond prices.
There is a risk of a dollar slump as foreign investors fearing that they will only be repaid in a devalued currency flee US bonds. The Chinese, key bond buyers, have already fretted publicly about the impact of inflation on their holdings.
However, since there is no clear challenger to the dollar’s role as a reserve currency, and “many other countries face the same headwinds” as the US, the dollar looks set for an “orderly decline”, says Morgan Stanley. Either way, it’s another reason to hold on to the ultimate currency – gold.