Could the US public debt lead to a "Liz Truss" scenario?

>> US sovereign debt is deemed riskier

Summers was referring to the plunge in gilt prices and the pound on the release of an unfunded tax-cutting mini-budget in September 2022 by Truss’s former chancellor Kwasi Kwarteng. Could the same happen in the US, as Summers’ claims?

We have to remember that as the US election nears, the commentary becomes even more partisan and, as a former Treasury Secretary under Bill Clinton, Summers’ has a clear agenda. Nonetheless, we might also point out that fears about escalating debt run across the political divide with pretty unanimous support for the view that the US is on an unsustainable trajectory as the debt/GDP ratio, which was just over 30% in 2000, is now near 100% and projected to rise to 122% over the next decade by the non-partisan Congressional Budget Office.

However, we are not really interested in whether this sort of outlook implies a slow and steady deterioration in treasuries and the US dollar. Instead, what we want to focus on is whether there could come a point, perhaps not long after the election, when debt fears reach such a pinnacle that we see a dramatic plunge in treasury prices and the US dollar.

Don’t forget that the “Liz Truss moment” referred to by Summers included a 135-bps rise in 10-year gilt yields in a week and a ten cent fall in sterling/US dollar in just three days. Could the dollar fall by almost 10% in less than a week if debt fears, provoked by a Trump win in November, mess with the markets psyche?

The reason Steve Barrow, Head of Standard Bank G10 Strategy is sceptical about such a collapse does not necessarily reflect the fact that we think the US debt position is in any way comfortable, or that it is in greater jeopardy if Trump wins on November 5^th. Instead, it is because the US dollar is not the pound. What does it mean by this?

Steve Barrow said that the US dollar has important characteristics that set it apart not just from the pound but from all other currencies. These characteristics include the US dollar’s dominant position as a reserve currency, a trade-invoicing currency and, most importantly of all, the predominant international currency for lending and borrowing. To see how this makes a difference, we need just reflect again on what caused the problems for the pound in 2022. Back then, the injudicious mini-budget put pressure on gilts and the pound and this pressure was quickly and hugely magnified by problems in the UK pensions and Liability Driven Investment (LDI) sector.

>> Different views on the US debt ceiling

In short, a reach for yield left the LDI and pension funds very exposed to rising UK rates. This caused a mad dash for cash and a subsequent demand for US dollars as LDI funds were forced to liquidate dollar-funded investments. The US dollar is not a currency that is primarily bought and sold; it is a currency that is mostly borrowed and lent through the FX swaps market. So, when LDI funds borrowed dollars through the FX swap market, the rapid requirement to pay down this lending to secure immediate cash meant a big demand for dollars against the pound in the spot market. And, of course, speculators from outside the pension/LDI sector jumped in on the act to redouble the pressure on sterling.

The pound collapsed because certain players in the market were short and had to buy back quickly. When we ask whether a similar sort of thing could happen to the US dollar, should US debt concerns mushroom over a ‘bad’ budget or injudicious fiscal promises, we have to remember that the US sits on the other side of this trade with its banks the primary lenders of dollars to the non-bank sector. It does not mean that a rapid and significant plunge in the dollar is impossible, but it is far less likely in Steve Barrow’s view.

The US is in a fortunate position, sometimes termed exorbitant privilege. In fact, it is notable that the Bank of England is now in the process of setting up a repo facility for the UK non-bank financial sector to try to stop any repeats of September 2022. That the US has not followed suit partly reflects the fact that the risks of currency and bond market implosion here are just not the same.