Related topics: stocks, debt, Federal Reserve, emerging markets, Jim Jubak
What happens in June when the U.S. Federal Reserve stops buying $100 billion in U.S. Treasury notes every month as part of the program of quantitative easing know as QE2?
You've heard the wails of worry. Which buyers, if any, will pick up the slack when the Fed exits this market? At the least, U.S. interest rates will have to rise to attract those additional buyers. At the worst, a lack of buyers will tip over the entire tower of cards that is U.S. government finances.
And I'm starting to hear another, still-building cacophony of worry. The Fed's most recent program of bond buying will have put $600 billion into the U.S. money supply by the time it's over in June. A significant portion of that hasn't stayed in the United States. Instead, some of that money has gone overseas, seeking better returns in Brazil, China, Turkey and Indonesia than it can get in any domestic U.S. market.
Jim Jubak
What will happen, the emerging worry goes, when this hot money starts to flow out of the financial markets in Brazil, China, Turkey and Indonesia? Won't the flight of this hot money create another global financial crisis akin to the Asian currency crisis of 1997 that brought the world to the brink of a financial meltdown?
The key thing that both these scenarios have in common is that they envision a big blow-up -- that things will go wrong quickly and in a big way.
Actually, I think, the most likely scenarios have less in common with the Hindenburg disaster than with a slow leak from an inflatable plastic model of the globe. In other words, the end of QE2 will bring not a bang of disaster but a whimper of pain. But investors still need to pay attention.
First worry: Who will buy our Treasurys?
Unless you've got some secret alternative global currency that investors, institutions and central banks can buy instead of the dollar, I don't think this question as dire as it seems.
The foundation of this worry is a belief that overseas investors have so many dollars already in their portfolios that they certainly won't buy more. At the moment, that does not seem to be the case. Foreign investors as a whole -- and this includes the world's central banks -- owned $4.45 trillion in Treasurys as of January 2011. That's up from $3.7 trillion in January 2010.
You may find this hard to fathom -- I know I've got trouble wrapping my mind around it. Given the size of the U.S. budget deficit, why would any sane investor buy U.S. government paper? The U.S. budget deficit for the fiscal year that ends in September is 10.5% of GDP. Greece, where 10-year bonds yield more than 13%, shocked investors when the 2010 budget deficit was revised upward to 10.5%. The yield on the 10-year Treasury is, in contrast, 3.41%.
But the United States is not Greece in some critical ways. First, Greece is saddled with the euro, which is run by a distant central bank. The United States, in contrast, controls its own currency. Greece can't depreciate the euro to restore the competitiveness of its economy. Instead, restoring the profitability of the deeply uncompetitive Greek economy so the country can pay off its debt will require very painful long-term reductions in the pay that Greeks take home for their work. Frankly, I doubt that Greece can get there using that method. The country will have to restructure its debt, even though its leaders are now insisting it has no intention of doing so.
The United States, on the other hand, can depreciate the dollar -- let the value of the dollar sink so that it can pay back what it owes in cheaper dollars. I know this possibility is often greeted with horror. The United States has no intention of paying back its debts, the criticism goes. It will just depreciate its way out of the current mess.
That is a problem, especially in the long run, if creditors decide that the United States lacks the intention or ability to pay its debts. Then the U.S. could see the same kind of buyers' strike that Greece, Portugal and Ireland have gone through -- but without the backup of buying from a central bank. There simply isn't a central bank in the world big enough to provide that support.
But a depreciating dollar that's combined with a reasonable budget-deficit-reduction plan is something else entirely. That's just business as usual: The world's bondholders recognize that the United States will have to let the dollar depreciate in order to reduce the U.S. balance-of-payments deficit with the rest of the world. An orderly reduction of that deficit because of a slipping dollar would, in fact, be a good thing in a world that can't keep running huge surpluses in some economies and a huge deficit in the United States.
Whether the world can engineer that kind of orderly rebalancing is an open question. Right now the odds aren't good. In fact, on April 18, Standard & Poor's lowered its outlook on U.S. debt to "negative," citing concerns that policymakers would not be able to agree on how to address the country's fiscal problems. Stocks plunged in response.
Foreign money has nowhere else to go, for now
The biggest thing the U.S. Treasury market has going for it is the disarray in financial markets that might otherwise provide reasonable alternatives in the volume that global investors need. The euro is still in crisis, and the euro bloc of nations looks further away from a solution to the problem than it did six months ago. Japan's budget is even further out of balance than that of the United States -- the yen may be a great currency to borrow if you want to invest somewhere else, but Japanese government bonds are even less attractive than U.S. Treasurys in the long run. The Chinese yuan may be an alternative to the U.S. dollar someday, but not until the Chinese government decides that its currency is fully and freely convertible.
All this may explain why, despite saber-rattling about diversifying out of the dollar, foreign central banks bought 60% of the $66 billion in 10-year Treasury notes sold this year.
As long as U.S. inflation remains subdued -- and the data released on April 15 show U.S. core inflation (the number the Federal Reserve cares about) running at an annual 1.2% rate as of March, with headline inflation at an annual 2.7% -- I think the Treasury market will be able to absorb the end of the Federal Reserve's buying program. U.S. interest rates may move up slowly as the U.S. dollar falls -- if the euro crisis moderates so that the European Central Bank can continue to raise its benchmark interest rate.
