Mounting uncertainty over the future direction of US fiscal and monetary policy could result in a spike in Treasury yields and large capital outflows from emerging markets, leading economists have warned.
Following credit rating agency Standard and Poor’s decision to cut its outlook for America’s credit rating from stable to negative on April 18, a decision which shaved 2% off the Dow Jones Industrial Average in early trading, before a mild rebound in afternoon trading saw the DJIA close down 1.14%, debt concerns remain arguably the most pressing near-term risk.
DEBT CEILING CONCERNS
Despite reaching last-minute agreement on April 8 to avoid a temporary US government shutdown, Congress has yet to reach agreement on raising the US’ debt ceiling, with some Republican lawmakers calling for faster and deeper commitments by the current administration to cut the deficit.
The Treasury Department estimates that the Federal government will hit its current $14.29 trillion debt limit on May 16 and Treasury Secretary Timothy Geithner has expressed confidence that a deal will be reached, warning in an interview with ABC on April 17 that a failure to do so would be “catastrophic” for the US’ global economic credibility.
Ted Truman, senior fellow at the Peterson Institute and former US assistant Treasury Secretary, told Emerging Markets that he believes that politicians will ultimately reach a compromise over the debt ceiling, because a failure to do so could prompt the US to default on its debt obligations and would severely damage its global economic credibility.
“Congress is playing a great game of chicken, but my assumption is we will not see the nuclear option,” he said. “The implications [of a failure to extend the debt ceiling] are mind-boggling.”
UNDERMINING FAITH IN TREASURIES?
A number of economists have warned that the scale of the US deficit has already begun to undermine confidence in US Treasuries, especially in light of the decision by Bill Gross, manager of the Pimco TotalReturn fund, the world’s biggest bond fund by assets under management, to reduce the fund’s Treasury holdings to zero last month.
Gross explicitly linked his decision to concerns over the US deficit, writing in his April Investment Outlook that Treasuries “have little value within the context of a $75 trillion total debt burden.”
Laurence Kotlikoff, professor of economics at Boston University, believes that even if an agreement on the debt ceiling is reached, that creditors were already losing faith in US Treasuries because of the government’s burgeoning debt.
“We’re not broke in 10, 20 or 30 years, we’re broke right now. Our creditors can decide that we’re bankrupt at any minute,” he told Emerging Markets.
“We’re going to see a lot of influential folks on the Street and in Europe start to draw the same conclusions [as Gross].”
YIELDS YET TO SPIKE
Nevertheless, there is little evidence so far that this is happening. Despite S&P’s debt downgrade, 10-year Treasury yields fell to 3.40% on April 18, following sharp falls in yields throughout last week and remain at historically low levels.
Truman believes that provided policymakers are able to extend the debt-ceiling, that debt concerns are unlikely to spark a run on US Treasuries or raise doubts about the government’s fiscal solvency in the near-term.
However, he warned that the US government’s “unsustainable” debt burden meant that creditors may start to question the quality of US government assets in the medium to long term unless a credible deficit reduction plan was agreed upon soon.
“I’m very hard-pressed to identify anything in current yields that suggests that we are close to a tipping point... but the problem is that the market doesn’t send a signal until three minutes before the fire is about to break out,” he said.
“You could have a sequence of actions, such as a government shutdown, a stalemate on the debt ceiling, which may force many Treasury holders to say ‘why do we want to fool around with this stuff anymore if the US government can’t put its house in order?’.”
POST-QE2 TIGHTENING BIGGER SHORT-TERM RISK
In the near-term, most economists believe that the Treasury’s policy path following the end of the second round of quantitative easing (QE2) at the end of June will have a greater bearing on Treasury yields, and on global investment flows.
Truman does not expect a significant increase in yields unless Fed Chairman Ben Bernanke hikes interest rates later this year as well, an event to which he assigns a 30-40% probability.
“I don’t think there’ll be a big hike in rates due to the end of QE2, but if the Fed also raises rates, that’s a different issue,” he said.
Larry Kantor, chief economist at Barclays Capital, does not expect a rate rise this year, but warned in his most recent quarterly outlook that when it happens next year, it will result in a reallocation of assets away from emerging markets, as investors adopt “a more cautious position” on risk.
Kantor added that the extremely accommodative nature of monetary policy in the US and across developed markets in general may exacerbate the risks of a reversal of capital flows when tightening does occur, as investors retreat to safe havens.
EM OUTFLOW RISK
Alberto Bernal, head of emerging markets macroeconomic strategy at Bulltick Capital Markets, warns that US tightening could spark capital outflows from Latin America in particular.
“US tightening is a material risk for Latin American economies,” he said. “When it happens, it will generate material depreciations of Latin American currencies and additional investment shifts from emerging markets to developed markets.”
Asian economists warn that the potential for US tightening could also result in capital outflows from the region. However, Vishnu Varathan, Asian economist at independent macro research consultancy Capital Economics, told Emerging Markets that his outlook depended to a large extent on whether the US decided to raise rates due to rising inflation, without a concomitant uptick in economic growth, or if it decided to raise rates on the back of confidence over the sustainability of economic growth.
“If the US starts to raise rates due to price pressures, without an upgrade in its growth, I don’t expect a reversal of fund flows [from emerging Asia to developed markets], as the growth differential will still be significant” he said. “However, if the Fed raises rates on the back of brighter growth prospects, then we could see a reversal of fund flows [out of emerging markets].”