In The U.S. Dollar - Unblinking in times of uncertainty?, I suggested that all about the reserve currency was not sweet roses and sunshine
None of the ‘tactical challenges’ confronting the currency has gained in clarity since publication, three weeks ago
- Tariffs are roiling international trade in waves of purposefully fostered uncertainty
- making inflationary anticipations probable...
- pushing the yields of long maturity bonds up with near certainty
- Interest payments on a $30 trillion federal debt, topping 100% of GDP, have become extremely costly
- estimated at $1.250 trillion over the next 12 months
- cornering debt to be refinanced at maturity ($9.2 trillion) and additional ‘new’ debt incurred ($2 trillion) at the short end of the yield curve (1–2-year maturities at most), highlighting investor prudence (and doubts) - no takers for long maturity commitments !
- The budgetary deficit, this year ($2 trillion) and the following years, deepens financial imbalance
- contributing to a debt-built-up, never quite immune to market turbulence and drifting, unstable like a flat-bottomed boat
- Foreign stakeholders, institutions and individuals invested in Federal debt (32% of total), are potentially becoming more unpredictable...
- trust is eroding…
Currency exchange rates are constituents of a global appreciation, a 'collective' give-and-take and a valuation depending on supply and demand
Ultimately a currency is benchmarked in relative terms by the perception of consistency between the monetary policy of the central bank and the economic policy of the government
Because the U.S. dollar acts as a pivot structuring Asian and European currencies, its benchmark as reserve currency is deeply consequential on monetary policies of allies and foes alike
Uniquely favored by the security and liquidity of its Treasury market, borrowings to cover the federal budgetary deficit have run up the debt over the past years – a supply which has found its counterparty in demand by private investors, supplemented by the Federal Reserve’s Quantitative Easing “money printing” experiments
This time may be different...or will it ?
The size of debt, exceeding this year’s GDP, is stressing the U.S. financial system because the stakeholders have very different priorities
- foremost, the U.S. Administration wants to lower the interest paid on Treasuries because, by the end of the budgetary year which runs from October ’24 to September ’25, the cost of interest will exceed the Defense budget ($1.1 trillion)
- the Federal Reserve has been pursuing Quantitative Tightening – reducing the load of Treasuries carried on its balance sheet by selling part of this US debt back into the market and reducing the money supply accordingly – probably not so much as a matter of principle as a way to keep the option for another round of Quantitative Easing ready for a future need
- With low real interest rates (discounting recorded inflation), and uncertainty about magnitude of tariffs on consumer pricing, a waiting pattern made sense and probably continues to do so
- foreign holders of approx. a third of Treasuries, essentially in medium and long maturities, are locked into large unrealized losses on these bond holdings (because the interest rates have risen much) and may be hard pressed to commit to more
- Out of a total amount outstanding of $28.7 trillion U.S. Treasuries, 32% are owned by foreign investors - $9 trillion of which official holdings are $3.9 trillion (90% invested in mid- and long-term securities)
Cutting through the political noise, the decisions of these three parties depend on one another
None of the parties can hope to fulfill his mandate more effectively by decisions made in isolation
Signaling is no small thing
- the federal government could signal its intent to reduce the budgetary deficit by marginally reducing expenditures and raising taxes
- the Federal Reserve could signal conviction that inflation is falling back in line
- foreign holders could signal their trust in public policy and their anticipation of falling rates
Neither party can afford to make the decision on his own because each individual choice depends on the success of the two others – which highlights a common thread, economic growth
Growth with higher tax collections will rein in the debt build-up, which will contribute to reduce pressure on interest rates across the entire yield curve, ease the pressure on the Fed and inform investors in the bond market (foreigner investors are not alone) of buying opportunities as yields drop
However, no one is holding his breath...
Signals ? What signals ?
The premises are not good – real growth does not seem to be forthcoming – federal debt is expected to increase – inflation remains a concern – foreign investors are sitting on the fence
Outlandish claims gain traction, a digital Potemkin-like facade promising a radiant tomorrow
1° Under the guidance of federal government, it is suggested that US and foreign businesses will invest large sums in short order – Europe ($600 bn), Japan ($550 bn) and South Korea ($350bn)
- How private firms will finance this endeavor under the guise of future growth remains unclear
- Large volumes of FDI (foreign direct investments) are the mirror image of a goods and services current account deficit, offsetting one another
- Capital flows (the FDI) move in the opposite direction to the goods and services trade claims (the deficit) that give rise to them
- Having it both ways, decreasing the deficit while increasing foreign investment into the U.S. is inconsistent...
2° Inevitability of tariffs filtering through in consumer prices, impacting the inflationary outlook, is widely downplayed, as is also the pressure on profit margins of businesses paying a share of tariffs, impacting their investment capacity
- Hesitant domestic consumers and weakened private investment potential will weigh on demand, at least in the short term
- Recent CBO projections accounting for an 18% increase in tariff rate for goods imported estimate additional budget revenue at $3.3 trillion over 10 years (2025-2035)
While actual impact of tariffs on consumer prices is impossible to measure today, it is fair to assume that at least two thirds of revenue generated by taxation will ultimately be shouldered by the U.S. consumer by way of price increases, $220 billion (out of $330 billion) - an approx. 10% increase on currently budgeted income taxes of $2.2 trillion
3° Market access charges imposed on foreigners holding U.S. assets make the rounds, this time under Mr. Miran's signature following a similar test balloon in Mr. Trump's previous administration (supported by Mr. Lighthizer, former U.S. Trade Representative)
- Conceptually understandable from the U.S. viewpoint because of favorable investment opportunities (vs ‘the rest of the world’)
- How this would play out, given the amount of federal debt financed by foreigners and of foreign equity investments, remains to be seen
The transformations introduced in international trade are radical, their impact will remain uncertain for a while and overlapping timeframes will send confusingly different messages
- Some effects on foreign imports, sharply reduced or halted altogether, are immediate while investments stimulated by domestic demand may take years to solidify (or may not happen at all)...
Growth at the end of the tunnel ...
Growth targets, skewed in favor of the American market under the negotiated tariff guidelines, is an experiment in the making, assuming resurgent domestic investments, strong exports powered by lowered exchange rates and healthy U.S. consumer demand
U.S. economic growth - a benchmark of success shared by the Administration, the Fed and foreign investors - would shift the paradigm by inducing collective and mutually supportive decisions
How the global economy will respond to the strong-armed American policies remains, perhaps surprisingly, little discussed
Globalization in the age of Trump will be the subject of a forthcoming note