TOKYO – As milestones go, the US national debt surging past the US$31 trillion mark is especially personal for Haruhiko Kuroda and Yi Gang.
The leaders of the Bank of Japan (BOJ) and People’s Bank of China (PBOC), respectively, run the overseas institutions sitting on the largest stockpiles of US government bonds. Japan has $1.23 trillion and China roughly $1 trillion.
In all, Asia holds about $3.5 trillion of Washington’s IOUs – and at arguably the worst moment possible.
Between US inflation at 40-year highs, the Federal Reserve tightening the most aggressively in 28 years and the dollar trading at sky-high levels, news that Washington’s debt load is nearly twice the size of China’s annual output is decidedly unwelcome.
For now, the dollar is holding its own, with its traditional role as safe haven remaining intact. Yet US debt reaching nosebleed levels means “the party’s over, everyone,” says Brian Riedl, senior fellow at the Manhattan Institute.
He was speaking for investors everywhere. But it is not just a shortage of safe havens – there are precious few havens, period.
Best of the worst
At the moment, the US currency benefits from a dearth of obvious alternatives.
The euro is at 20-year lows amid slowing growth and political shakeups in top economies including Italy. The yen is down 25% this year as Asia’s No 2 economy leaves interest rates at historic lows. Lacking full convertibility, China’s yuan lacks sufficient liquidity.
The pound is just about bouncing back from record lows against the dollar as new Prime Minister Liz Truss stumbles, disastrously, out of the starter gate. Markets are unimpressed.
On Thursday, Fitch Ratings downgraded the UK’s sovereign debt outlook to negative from stable. As analyst Craig Erlam at OANDA observes, London’s “overall rating remained at AA- but that may change once the details of how everything will be paid for are released in the budget.”
Cryptocurrencies look about as stable an alternative as the tulip bulbs of old. Commodity price charts, as one Singapore-based trader puts it, “are looking like an electrocardiograph registering a heart attack. No store of value there. So, the dollar rallies.”
In an October 7 report, S&P Global Ratings noted it’s unclear how global policymakers can slow the rise of a dollar that’s up more than 17% on a trade-weighted basis this year.
“We appear to be entering the third dollar boom period in the past 50 years,” says S&P Global Chief Economist Paul Gruenwald. “There is no easy solution: passivity endangers inflation targets and credibility, rate rises risk lower output and employment, intervention is likely to burn through precious reserves.”
Washington’s runaway debt is causing intensifying headwinds at home, too. Case in point: widespread reports of liquidity problems with US bond trading.
Strategist Krishna Guha at Evercore ISI says the “appreciable and troubling deterioration in Treasury market liquidity” tells a bigger story about where the global financial system finds itself as 2023 approaches. The fact it’s getting harder to buy or sell the safe haven asset is a strong warning sign.
Look no further than Japan, where secondary bond trading is becoming a relic of the past. BOJ Governor Kuroda has hoarded so many government bonds that it’s become hard to trade securities at all.
Of course, the plights of Japan and the US are mirror images. Japan’s problem is too much central bank liquidity; America’s is aggressive Fed tightening. But the fact that two of the biggest debt arenas face market-depth problems — where even huge trades fail to move prices — suggests the global financial system is in a bad place.
Lehman Brothers #2?
Chatter about troubles at Credit Suisse is fanning a whiff of 2008 fears among investors and government policymakers alike. It means the Fed and other top central banks could soon face a dangerous “credit event,” says Komal Sri-Kumar, the president of Sri-Kumar Global Strategies.
“I think the Federal Reserve is going to have to face the consequences of a credit event” if it were to occur, Sri-Kumar tells CNBC. “Something is going to break.” He adds that “this may or may not be a Lehman moment.”
At a minimum, Fed officials will have to recalibrate interest rate hike plans. In early 2020, US Fed Chairman Jerome Powell’s team acted as buyer of last resort as Treasuries market dealing went haywire. The Fed could be forced to take similar actions in the weeks and months ahead.
Some argue that fears about Credit Suisse’s solvency are overblown. Among them, Boaz Weinstein, founder of Saba Capital Management, warns against “scaremongering” about the state of the bank’s credit default swap profile.
Markets, he says, shouldn’t make the mistake of “confusing steeply falling equity with default risk. Is General Motors also on the brink of failing? Their CDS is identical to Credit Suisse. We should be careful not to yell.”
But many traders can’t help but recall similar arguments made in the weeks before the September 2008 collapse of Lehman Brothers.
Alasdair Macleod, head of research at investment firm Goldmoney, observes that “Credit Suisse is not the only major bank whose price-to-book is flashing warning signals,” warning of strains facing Deutsche Bank, Credit Agricole and other top names. “A failure of one of them,” Macleod says, “is likely to call the survival of the others into question.”
As these worries play out, the background music of the global system is that of US Treasury securities hitting liquidity troubles. This puts Asian central banks in a precarious place – and at growing risk of not finding a chair if the music stops.
Asian vulnerabilities
Granted, China has been reducing its US debt holdings over the last year. Theories why run the gamut.
Some argue PBOC Governor Yi is drawing down dollar holdings to help stabilize the yuan, which is down nearly 12% this year. Others believe Beijing is trying to complicate life for US President Joe Biden amid rising geopolitical tensions. Or China could be making a wise financial bet.
President Xi Jinping’s team has been increasing financial ties with Russia at a moment of maximum tension between Vladimir Putin and Biden’s White House. Nikkei Asia reports that China has stepped up efforts to move some debt into offshore tax havens where any future US sanctions can’t reach.
But concerns about Washington’s fiscal trajectory are bound to increase among America’s top bankers here in Asia. When former US president Donald Trump signed a $2 trillion tax cut in 2017 and as Biden now ramps up infrastructure spending, they rely on savings from Japan, China, Hong Kong, South Korea, Taiwan, India and others.
The odds that Asian central banks might add to their dollar exposure are dwindling fast, even amidst a dearth of ready alternatives. The kind of selling the US is seeing from China raises eyebrows in Asia – and tempts smaller dollar holders to attempt to front-run any bigger moves by Beijing and Tokyo to dump dollars.
For Singapore, South Korea, Thailand and others, there’s an obvious first-mover advantage. But there’s a mutually-assured destruction dynamic at play here.
Over the last 15 to 20 years, the symbiotic financial relationship between the US and China has been arranged around the assumption Beijing will stay invested in US Treasuries and Washington would be a responsible steward of Asia’s money.
The fallout of the breakdown of this relationship is impossible to calculate. Suffice to say, financial chaos would ensue. It’s an open question whether US debt topping $31 trillion is a “very large problem” for US-China dynamics, as economist Alex Pelle at Mizuho Securities puts it.
America’s conundrums
Darrell Duffie, a Stanford University finance professor, adds that “the US Treasury market is the most important securities market in the world and it’s the lifeblood of our national economic security. You can’t just say we hope it will get better. You have to move to make it better.”
For now, “market liquidity is definitely lower,” New York Fed President John Williams told reporters earlier this week. But, he stressed, “it’s still functioning.”
Yet, notes economist Josh Younger at JPMorgan Chase, US officials have some work to do if Treasuries can “serve the purpose for which they have been anointed, which is a cash substitute, the intermediation mechanism” of international finance and trade.
Michael Peterson, CEO of the fiscal watchdog non-profit-organization Peter G Peterson Foundation, says that “as our debt crosses $31 trillion, it’s past time for action. For too long, policymakers have assumed perpetually low-interest rates, and we are now seeing in real time how dangerous that assumption is.”
Princeton University economist Owen Zidar worries that further Fed rate hikes won’t just increase Washington’s debt burden but force Washington lawmakers to take some uncomfortable votes. Zidar says those moves should include tax increases for the wealthy and closing loopholes on carried interest.
In the meantime, a surging debt load will only exacerbate Washington’s challenges. “The US economy is likely to deteriorate in 2023 with consumer spending and business capital expenditure set to fall, while unemployment is likely to rise,” says economist Carsten Brzeski at ING Bank.
“We expect a 75 basis-point rate hike from the Federal Reserve in November and a further 50 basis points in December,” Brzeski says. “But mounting concerns about growth and the housing market are likely to lead to rate cuts from the third quarter of 2023.”
Amid so many challenges, Washington’s fast-rising debt load “is a new record no one should be proud of,” says Maya MacGuineas, president of the Committee for a Responsible Federal Budget.
“In the past 18 months, we’ve witnessed inflation rise to a 40-year high, interest rates climbing in part to combat this inflation, and several budget-busting pieces of legislation and executive actions,” says MacGuineas.
His conclusion is grim: “We are addicted to debt.”
Follow this writer on Twitter @WilliamPesek