Dear Reader,
Per our oft-repeated prognostications that the housing bubble and credit crisis will morph into a currency crisis, the list of countries whose sovereign debt is now being looked at suspiciously is growing daily.
Among those on the watch list are Greece, Dubai, Ireland, Italy, Spain, Ukraine, Mexico, and Austria. Even the debt of the UK and the U.S. is now reaching levels that could soon require a re-rating in the wrong direction.
Put another way, the space between the rock and the hard place is noticeably tightening.
Says Moody’s Investors Services in its Sovereign Risk: Review 2009 & Outlook 2010 report…
For most of 2009, the assumption was that governments could decide on the timing: first react to the crisis, then announce future plans, and finally implement. Such an assumption may be proven wrong... Aaa countries will probably not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans.
In plain English, what Moody’s is saying is that best-laid plans aside, in order to avoid a currency crisis, the heavily indebted countries are going to have to start unwinding the quantitative easing that has been their only important response to their predicament .
Which further means, stop flooding the world with funny money and proactively increase interest rates.
Of course, rising rates will grab any nascent economic activity by the throat and give it a good throttling.
Given the importance of these latest, albeit entirely predictable, developments, a few more words on the topic are in order.
As you don’t need me to tell you, unleashing a wave of money has been the default “solution” of most governments to the current problems. Money, created out of thin air.
The money may have bought some small respite – shoots of an anaemic shade of green – but even the briefest glimpse at the dire unemployment numbers reveals how weakly those shoots cling to life.
The money flood, based as it is on sovereign debt, has driven that debt to elevated and even extreme levels.Incredibly, the world’s governments have tried to solve the problem of too much spending and too much debt with yet more spending, begetting yet more debt.
Unfortunately for these governments, this misguided “solution” is now reaching the end of its usefulness; they are damned if they do (issue more debt), but equally damned if they don’t.
This is because the herd of globally active institutional investors can now clearly see the debt trap for what it is, and so, rather than being comforted when officialdom harrumphs that more spending and debt is required, they are distinctly discomfited. The herd is beginning to edge away from the game table and demanding a bigger upside in order to play at all. When it comes to debt, that upside invariably is expressed in higher interest rates.
Given the aforementioned throttling effect of higher rates and the markedly negative effect high rates have on government finances, how, pray tell, will the government respond?
Typically, central banks have a lot of influence over short-term rates, but that influence declines with duration. The mechanism is relatively simple. The Fed can issue 30-day or 3-month paper with almost any rate on it – even zero – and investors looking to park cash may still buy the stuff because of the sovereign guarantee and because, hey, how much can you lose in 30 days, or even 3 months, on the debt of a reasonably stable country?
But when you start talking bonds of 10- to 30-year durations, the amplifying effects of even a whiff of inflation in the air will spook all but the dumbest of money.
So far in this crisis, long rates in the U.S., the lynchpin country for the global economy, have remained remarkably low – given the monetary inflation that is there for all to see. Why? Who would be so stupid as to buy long-dated Treasuries with yields so low, they are for all intents and purposes in negative territory?
Deflationists. Because of the size of the debt problems going into the crisis, there has been a significant pool of investors willing to bet on a deflationary crash. To wit, that the Fed’s ability to inflate would be outstripped by the implosion of trillions of dollars of misallocated capital.
Currency competitors. Countries with a vested interest in supporting their own export industries by propping up the dollar have been willing to help lift the load, even by buying longer-duration bonds.
The buyer of last resort. The Fed has purchased some $300 billion worth of Treasury paper and over a trillion in various toxic assets, much of it associated with mortgage paper.
Looking at those three categories of buyers today, a changing picture emerges.
The deflationist argument has been refuted by the sheer scale of the quantitative easing – a spend-a-thon of epic and unprecedented proportions.
If there’s a limit to federal fiscal prolificacy, it is not yet apparent. As recently as this past week, President Obama and others in his administration have reiterated their strong opinion that more spending is the key to recovery.
The currency competitors are now focusing almost exclusively on shorter-term paper, the kind that can only bite you a little and not a lot. I’m not sure what yield would be required to get the Chinese, the Japanese, or the oil sheikhs to buy any more than a token amount of 30-year Treasuries, but you can make a firm bet that it will be more than the paltry 4.52% now on offer.
And the Fed? Rock and a hard place. For now, their only way out is to churn a lot of short-duration paper, but any serious move to monetize the long-dated stuff would likely make the currency crisis not only inevitable but imminent.
Meanwhile, the shift to short-duration paper primes the fuse on a very large keg of powder, requiring that the government engage in non-stop operations to roll the paper over, at the same time that it needs to move trillions of dollars of new debt.
Governments the world over experience the same situation as they desperately grasp for a way out from under the legacy problems they have inherited and/or helped to propagate. The U.S. has an inherent advantage over most, because of the interest other countries have in seeing the dollar strengthen. But that advantage is not indelible.
To restate things, the problem faced by the sovereign issuers of debt is debt. Their existing debts, and the additional debt they need to issue in order to maintain the spending needed to ameliorate soaring unemployment and other symptoms of past financial mistakes. Time is now of the essence, and the risk of social unrest is becoming more likely with each passing day. At the rate things are going, Berlusconi may not be the last member of the power elite to catch a statuette in the snout.
The endgame is coming, because the situation is rapidly becoming circular. The governments will spend because they must, but they are increasingly being squeezed into shorter-term issues and, soon, shorter-term issues with higher and higher rates. And all of this against an environment of steeply rising long-term rates.
We’re on the verge of a vicious cycle leading to global currency crisis. And time is running out for making preparations.
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