By Salman Ahmed
In his recent New York Times blog, Nobel laureate Paul Krugman took a sharp swipe at some famous experts (“the scaremongers”), who he thinks subscribe to “fantasies of fiscal apocalypse”.
On this front, we agree with Dr. Krugman that comparisons invoked by experts such as Alan Greenspan between the US and Greece are way off the mark. In lending/borrowing markets, the absolute size of debt matters. Using Keynes’ words, “if you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy,” hammers home the point clearly. With China, Japan and now the Federal Reserve holding the vast majority of US government-issued debt, it is easy to work out that none of these big creditors have a strong incentive to initiate a run on US government debt on the back of fiscal worries.
China and Japan still rely on the export model to generate growth in their economies and in this export-led system, the heavyweight demand (by a margin) comes from the US consumer. Hence, from the perspective of the Chinese and Japanese governments, taking a decision that increases the cost of funding for the US consumer has a strong side-effect in the form of a negative external demand shock for these countries, which we estimate will be enough to push them into a deep recession. From the Federal Reserve’s perspective, the dual mandate – which includes the strong emphasis on employment – means that a sharp rise in interest rates will be considered a negative demand shock with negative implications for labour market dynamics. Indeed, the outgoing chairman, Ben Bernanke, has already indicated that it is unlikely that the Federal Reserve would ever sell the treasuries sitting on its balance sheet and any exit from the QE programme would be a very gradual one.
Again, here it is easy to see that the central bank is unlikely to react to any deterioration in fiscal flows, given treasury holdings and current buying is a monetary policy tool, rather than an asset that generates income or capital gains or a store of value that is affected by underlying credit concerns. Furthermore, the fact that the US issues debt in its own currency is a powerful backstop against shifting investor sentiment. Inflation as always is the key risk factor here, but as we have seen, the quantitative easing programme is neither a necessary nor a sufficient condition for run-away inflation in a world of low money velocity.
Finally, it is important to note the difference between 2008 and any potential run on the US government debt market. The story of 2008/9 was one of over-borrowing by the private sector, leading to a housing market collapse, which in turn exposed the linkages between the financial and real sectors of the economy. Under this scenario, bond yields fell as safe haven demand increased and growth and inflation expectations were revised down.
On the other hand, a market-induced de-leveraging of US government debt is a different matter as it would entail a sharp rise in bond yields irrespective of current and forward economic expectations and as we note above all the key players involved in this setup have little incentive (especially with inflationary dynamics so benign) to initiate such as shock, given the huge negative externalities attached to such a decision.
Turning to current monetary policy considerations, we continue to believe we are likely to see several cycles in policy thinking and its implementation by the Federal Reserve, which is likely to use a trial-and-error approach to policy calibration (the summer months were a good example). In that kind of environment we strongly believe that a long-only fixed income benchmark approach appears to be ill- suited to deal with any increase in uncertainty .
Salman Ahmed is a strategist on the Global & Emerging Fixed Income team, Lombard Odier
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