Debt woes for the US dollar

The issue of high and rising government indebtedness, particularly in the US, has been in the news recently. Photo: Treasury Secretary Janet Yellen

The IMF, for instance, cast aspersions on the fact that the US budget deficit is destined to remain large even though the economy is at full employment. And, of course, the sharp rise in treasury yields recently has been partly ascribed to the worrying deficit and debt outlook. But these sorts of concerns often spring up from time to time. Should we be any more worried than before? Mr. Steve Barrow, Head of Standard Bank G10 Strategy, thinks there could be reasons for concern.

To see this, we need to sort the wheat from the chaff. What we mean by this is that we can disregard many of the current concerns about US debt, but need to respect some of the longer-term problems. Current, or recent issues such as the political problems in raising the debt ceiling and avoiding a government shutdown are not a genuine source of long-term concern. They have flared up occasionally, and will undoubtedly do so again in the future. Instead, what we are more concerned about is the longer-term outlook for debt sustainability; in particular the threat that real (inflation-adjusted) interest rates remain above the economy’s long-run growth potential.

The Fed puts this potential at 1.8% and if we look at the real rate on 5-year notes (which is slightly below the average maturity of US debt) it stands at 2.4%. It is uncommon for real rates to be above the growth rate outside of recessionary periods. Why is this important?

It matters because it implies that the economy is not growing fast enough to pay down its debts, potentially creating an explosive path for debt if politicians cannot get a grip on the budget. Of course, it is very possible that real rates come down again but as we’ve argued recently, any decline seems likely to be temporary and, instead, it is far more likely that real rates remain at levels far higher than those seen in much of the pre-pandemic period.

Hence, from this perspective, at least, there seems some reason for concern. But even if the debt ratio rises far above its current level of close to 100% of GDP will that be a problem? After all, Japan has a debt/GDP ratio of 260%. It could matter because the US owes much of its debt to the rest of the world, with its net international investment position (NIIP) in the red to the tune of over USD16tr. In contrast, Japan owes much of the debt to itself and this helps take away some of the vulnerability in both the bond market and in the currency market.

In other words, the key here is not to think debt sustainability becomes a problem when it reaches a certain level of GDP, but instead to consider whether overseas investors will be willing to absorb all the debt the US needs to sell them without a sharp rise in yields and/or fall in the dollar. On this score, it is worth noting that the US still has a large external (current account) deficit and that the IMF, for one, thinks that the dollar is around 10% too high to bring this external deficit down to a sustainable level.

In simple terms, the risk is that investors outside the US could be required to absorb ever increasing amounts of US debt at a time when the dollar is already far too high. These sorts of concerns about debt and US dollar sustainability were in vogue back in the mid-1980s, during a similar period of high inflation, high rates and rising deficits. It was also a time when the dollar was very high – somewhere around 62 cents for Germany’s equivalent of euro/dollar compared to today’s rate of 1.05.

However, in real effective terms, the US dollar is only around 10% below the peak seen in 1985. So, this double whammy of excessive debt and an excessively high dollar could still come back to bite the US. Of course, the advantage the US has over others is that the dominance of the US dollar, and particularly its “safety”, means that overseas investors are willing to cut the US more slack than they would other countries.

“This safe-haven premium, and historically high US rates appear might be enough to keep the US dollar in the ascendancy now but, in our view, longer-term storm clouds are gathering that will push the greenback into a long-lasting downtrend that will unwind all of this near-10% overvaluation of the currency, and more”, said Mr. Steve Barrow.