In his latest GREED & FEAR report, CLSA’s Chris Wood argues that the biggest risk to the global economy is, quite simply, a US sovereign debt crisis.
So far the market isn’t showing any signs of worry, as Wood admits.
Here’s how you’ll know there’s trouble:
This is why in GREED & fear’s view the biggest systemic risk in the world is now a US sovereign-debt crisis, which would likely mean the end of the US dollar as the world’s reserve currency. The sign that this risk is becoming real will be when the US Treasury bond market starts to trade on supply dynamics, in terms of the amount of bond issuance, as opposed to the perception of the health of the economy. It should be stressed that, for now at least, GREED & fear’s view remains that the Treasury bond market is trading on investors’ view of the economy. The rise in the 10-year Treasury yield from a low of 2.38% in October 2010 to a high of 3.74% in February reflected growing cyclical optimism on the US and coincided, logically, with the rally in US equities. Conversely, the 57bp decline in the 10-year Treasury yield from early February to mid March reflected renewed risk aversion and a stalling of the stock market’s advance (see Figure 7).
Obviously, Wood doesn’t buy the idea that since the US controls its own money, it can’t be compared to the Eurozone periphery.
Still, as last year’s crisis in Euroland’s periphery sovereign bond markets showed, when supply concerns finally hit a government bond market the reaction can be violent. The reality is that America is more clearly than ever on the path to a sovereign-debt crisis. First, the Federal Reserve is well on the way to monetising the deficit. For this fiscal year, it is estimated that the Fed’s purchases of Treasury bonds under the QE2 programme, together with the reinvestment of principal payments from agency debt and MBS into Treasury bonds, will be equivalent to 55% of the federal government’s projected budget deficit of US$1.65tn. Indeed, the Fed’s outright purchases of Treasury bonds in the three months to March accounted for 94% of net Treasury bond issuance over the same period (see Figure 8). Second, the federal government’s fiscal condition has deteriorated dramatically ever since the massive bailouts and aggressive stimulus prompted by the financial crisis.
Skipping ahead, Wood offers this comparison between the US and Japan:
One way of looking at fiscal vulnerability is sovereign-debt issuance as a percentage of central- government expenditure. On such a matrix, Japan has looked bad for some time. Projected new JGB issuance is running at 48% of government spending this fiscal year (see Figure 10). But more interesting to GREED & fear, in the case of America this same ratio is deteriorating fast. Gross Treasury bond issuance as a percentage of federal-government outlays has risen from 27% in 2007 to 66% in 2010 (see Figure 11). But remember, the key difference with Japan is the continuing dependence for now on foreign buyers of Treasury bonds.