The good cop-bad cop routine that Jerome Powell and Janet Yellen attempted on Tuesday is aimed at an obvious audience: America’s bankers in Asia.
The last month has been a real eye-opener for the keepers of the US dollar and the most important debt market. A disastrously weak February 25 auction of 7-year notes hinted at the demand problem investors have been fearing for more than a decade now.
A perennial question since the 2008 subprime debt crisis is whether Asian central banks will continue gorging on US debt. Even more so since 2011, when credit rating agency Standard & Poor’s yanked away Washington’s AAA rating.
That downgrade made then-Chinese Premier Wen Jiabao seem clairvoyant. Two years earlier, in 2009, Wen pleaded with Washington to be a better steward of the more than US$1.1 trillion of Treasury securities Beijing holds.
As Wen put it: “We have made a huge amount of loans to the United States. Of course, we are concerned about the safety of our assets. To be honest, I am a little bit worried.” He urged the US “to honor its words, stay a credible nation and ensure the safety of Chinese assets.”
The decade since has only exacerbated Asia’s concerns about its trillions of dollars of Treasury holdings.
The Donald Trump era gave Wen’s successor Li Keqiang and President Xi Jinping even greater reason to fret about the safety of Chinese state money. Even before Covid-19 arrived, Trump administration spending was next-level, making S&P’s 2011 call seem prescient.
Trump’s disastrous handling of the pandemic has since necessitated trillions of dollars of rescue spending, putting the US on course for a $30 trillion national debt.
Bear market territory
It also has punters tiptoeing up to foundational questions about global markets. Over the last year, key measures like the Bloomberg Barclays US Long Treasury Total Return Index, which centers on debt maturing in 10 years or longer, fell about 22%.
That’s the “worst drawdown going back 40 years” and denotes bear-market territory, says Rick Rieder, chief investment officer at BlackRock. “We’re in the midst of witnessing bond-market history.”
The massive plunge in the Turkish lira, meantime, speaks to how quickly the mere whiff of higher US yields can add to the turmoil roiling emerging markets.
Enter Joe Biden, to whom it falls to rebuild global confidence in the US. Last month, his new administration pushed through another $1.9 trillion of rescue spending. To which Asia retorted: Not so fast, Mr President. The US may have built a giant and innovative economy, but Asia, remember, holds the mortgage.
The 7-year auction debacle assigns outsized importance to the next one – on Thursday.
The level of demand for this week’s sale of $183 billion of notes will be scrutinized in Asia like few auctions before it. The sale is also a litmus test of whether China, Japan, South Korea, Hong Kong, Taiwan, Singapore, India and other top US bankers will help Biden finance what’s to come.
US debt issuance in 2021 is estimated to surge to $4 trillion, according to Dutch bank ING. On top of that, Biden is rolling out a multi-trillion-dollar infrastructure spending program, one that assumes Asian savings will continue flowing America’s way.
But will it? The Powell-Yellen tag team display for Congress this week highlights this tension.
In their routine, Powell is cast as good cop to Yellen’s bad. Yellen’s job is to telegraph the extent to which the Biden White House plans to spend big on building economic muscle. Big enough to give big debt traders indigestion and spark concerns about the private sector getting boxed out of the market.
Whereas Trump borrowed big to cut taxes for the 1%, Team Biden is looking to correct decades of infrastructure neglect. Done competently, spending to upgrade roads, bridges, ports, power grids and telecommunications hardware could boost American productivity to create jobs for the 99%.
Powell’s role is to reassure US debt holders that things will be alright. To those worried that inflation is about to surge, Powell says the hardest-hit sectors amid the pandemic “remain weak” and that the unemployment rate “underestimates the shortfall.” In other words, don’t fret overheating.
Yet count Ray Dalio, the founder of Bridgewater Associates, among those intrigued by Powell stressing that recovery moves are “far from complete.” To Dalio and his ilk, that’s sure to include the Fed stepping into territory anathema to monetary policy purists like the late Milton Friedman.
At issue, as Dalio sees it, is an intensifying “supply-demand problem for bonds” that the Biden White House might not have anticipated. Speaking at the recent China Development Forum, Dalio said any fresh spikes in US yields “will prompt the Federal Reserve to have to buy more, which will exhibit downward pressure on the dollar.”
Globally, nearly $14 trillion of public debt carries negative yields, according to Bank of America. That calculus could change quickly should US rates surge, a risk last month’s weak auction put in stark relief. Already, Powell’s Fed buys roughly $120 billion in bonds per month. The odds are, Dalio says, that number will rise markedly.
‘A great job so far’
Might Powell’s team go a step further and monetize debt? In other words, will he purchase bonds directly from the Treasury, as we’re seeing in Indonesia and perhaps soon in India? Yes, says Columbia University’s Willem Buiter. “Simply put,” he says, “the additional federal fiscal deficits must be monetized.”
In general, Buiter thinks Powell’s team “has done a great job so far” expanding its balance sheet by 70% from March 2020 to January 2021 – from $4.2 trillion to more than $7.4 trillion. “But the Fed now must prepare to buy up the federal debt issued by the Treasury to fund its latest fiscal ambitions,” Buiter argues.
That means, Buiter says, “expanding its balance sheet by up to $2.8 trillion, in order to accommodate December’s $900 billion consolidated appropriations act and the forthcoming $1.9 trillion Biden package. Such action from the Fed would alleviate concerns about fiscal sustainability and crowding out private investors.”
It also would fuel other concerns. One is inflation, which is a key concern for economists including those at Deutsche Bank as they assess Bank Indonesia’s policy of buying debt directly from the Finance Ministry. That, after all, was a key side effect of Japan’s 1930s reflation efforts.
Another worry is what economists call “moral hazard.” Sohaib Shahid at TD Economics notes that monetization of public borrowing is often viewed as “good politics.” Any government, he says, “would welcome lower bond yields caused by the purchase of government debt by the central bank.”
Yet that support could incentivize bad behavior. Governments might borrow with even greater abandon – and be tempted to make the arrangement permanent.
In Indonesia’s case, says Fitch Ratings analyst Thomas Rookmaaker, observers are hanging a lot on Jakarta’s “assertion that the move is a one-off driven by the unusual circumstances of the pandemic.” If the policy is extended, he says, “it would raise the potential for government interference in monetary policymaking and could undermine investor confidence.”
One last consideration is what if monetization doesn’t work? As economist Michael Spencer at Deutsche Bank points out, authorities assume that by intervening in the primary bond market they can cap yields, calm investors and attract foreign capital.
The risk is that foreign investors take a pass anyway. And that, in Spencer’s view, “all this printing of money would depress the currency, which could lead to even more outflows.”
Powell may assume a certain Fed omnipotence here. Judging by America’s good fortune since 2008, this isn’t completely unfounded. After Wall Street’s epic tumble, there was breathless speculation that Asia might pull the plug on the dollar. Hence Premier Wen’s 2009 admonishment of US fiscal shenanigans.
In 2017, there was chatter about a politically-driven US debt fire-sale as Beijing retaliated for the trade war. The fear was that China would use its financial leverage as revenge against Trump’s tariffs by selling large blocks of Treasury debt.
At the time, pundits pointed to comments 20 years earlier by then-Japanese Prime Minister Ryutaro Hashimoto. In a rather dry 1997 speech in New York on US-Japan relations, Hashimoto admitted that “several times in the past, we have been tempted to sell large lots of US Treasuries” to make a political point. One such episode was the heated auto negotiations a few years earlier.
It never happened, though. US government debt only grew in scale and supremacy in the years since. Any risk-off pivot by investors still had capital rushing into Treasuries. Europe’s multi-year debt travails dented the euro’s utility as a safe haven. Tokyo’s government bonds have become less and less liquid as the Bank of Japan corners the market.
Yet the Covid-19 crisis did trust in US institutions no favors. Nor has Trump’s anti-China rhetoric surrounding the coronavirus earned the US much goodwill in Beijing.
Trump further complicated a dynamic that former US Secretary of State Hillary Clinton spoke of in 2009. Back then, around the time China’s Wen was worrying about the safety of US debt, Clinton remarked: “How do you deal toughly with your banker?”
In 2011, around the time S&P was downgrading the US, the state-run People’s Daily ran an editorial arguing “now is the time for China to use its ‘financial weapon’ to teach the US a lesson” regarding its support for Taiwan.
This seems even less likely now. Pulling the “nuclear option” of dumping US Treasuries would be mutually-assured-destruction. The fallout would boomerang back on Chinese exporters and global rates would surge.
But Xi has a fresh advantage. Over the last year, though, China’s yuan – and Beijing’s $16 trillion government debt market – has begun to emerge as a viable alternative. Since 2016, when the International Monetary Fund slapped a reserve-currency label on the yuan, Xi’s government worked steadily to stabilize the financial system, increase transparency, journeying toward full convertibility and to accord the People’s Bank of China flashes of independence.
The yuan’s arrival complicated things further for Biden. It means the US can no longer take for granted healthy overseas demand for its debt. Hence Powell essentially joining hands with Yellen, his predecessor at the Fed, to reassure markets there really is a method to today’s financial madness in Washington.
Part of Yellen’s plan is stressing that the ends justify the means. Her pitch: if money is borrowed to invest in a more productive and vibrant economy – rather than squandered on Trumpian trickle-down-economics giveaways to the uber-wealthy – it is less reckless. Yellen stresses, too, that some of the coming infrastructure bill will be offset by tax increases aimed at boosting revenues.
In a recent Washington Post op-ed, Fareed Zakaria pointed out that Washington’s F-35 fighter jet program, plagued by cost overruns and technical flops, will ultimately cost taxpayers $1.7 trillion. China is lavishing a similar amount on a “Belt and Road” juggernaut creating greater interdependence between pivotal developing nations and China. Which is money better spent?
Biden’s “Build Back Better” extravaganza so far carries a $3 trillion price tag. The catch, of course, is that Biden’s Democratic Party will be relying on China, Japan, Hong Kong, Taiwan, Singapore, India and top Asian bankers to finance those upgrades.
Will those governments be willing to increase their US exposure? Thursday’s auction could provide some clarity. But Biden’s supply-demand troubles may have only just begun. If so, Powell’s Fed might have to pick up unthinkable amounts of slack come auction time.