World War C: Will Rising U.S. Deficits Steepen The Yield Curve?
- Estimated Deficit Spending for 2021
- Modern Monetary Theory (MMT) – Version 1.0
- The U.S. Dollar Stays Strong
- Drowning Out The Noise
- What Opening Up May Look Like
The economic toll, as measured by deficit spending, is going to set new records across most modern economies. Even Germany is implementing deficit spending. So, what does this mean for the future of U.S. Treasury yields/interest rates?
Estimated Deficit Spending for 2021
The United States’ fiscal year ends on September 30, so the revenue received in the current year 2020 was mostly earned in the prior year of 2019. The budget deficit prior to the pandemic for 2020 was estimated to be roughly $1 trillion. Let me restate to be clear: before Covid-19 was a word, the U.S. government was on track to spend $1 trillion more than they received in taxes.
Normal recessions cause tax revenue to decline and expenses to increase, thus increasing deficit spending. The Great Recession caused the U.S. deficit to increase by an additional $1 trillion. World War C will cost the U.S. more in revenue than 2008, but to make the math simple, let’s just assume an additional $1 trillion in deficit spending caused by the Covid-19 recession for the fiscal year of 2021. When you add the pre-Covid-19 deficit spending plus the additional amount caused by the Covid-19 recession, this amount totals a $2 trillion deficit in 2021. Once again, this is a low-ball estimate.
The U.S. Congress has so far passed legislation to spend $2.5 trillion to support our economy during this difficult time, which will mostly hit the U.S. budget in 2021. God only knows how much will be spent when this is all over, but I will keep future Covid-19 stimulus spending out of our calculations for now. If we add stimulus deficit spending and my estimation of the budget deficit for 2021, it equals (2.5 + 2) = 4.5 trillion dollars.
In 2019, deficit spending in the U.S. as a percentage of GDP was 4.6%. 2021 GDP calculated in U.S. dollars is estimated to be 20.3 trillion. I am being generous because Covid-19 is going to cause GDP to decline. As a percentage of GDP, deficit spending for the U.S. in 2021 will be approximately (4.5 / 20.3 = 22.17%). My numbers may be off by a few 100 billion or so, but I think you get the picture. It is not pretty. Can you imagine what the deficits for some European countries are going to be in 2021? We will discuss this in more detail in a future letter.
Modern Monetary Theory (MMT) – Version 1.0
So why am I telling you this information? Because I am starting to get questions about the flood of U.S. debt to pay for massive deficits. Readers are worried that the increasing supply of U.S. Treasuries will cause yields to spike and steepen the curve. Here is what I know for sure: if something can’t happen, then it won’t happen. Let me explain.
Currently, the Fed is buying billions in U.S. Treasuries per day in the secondary market. Depending on how long QE4 lasts, the Fed is on track to purchase hundreds of billions and possibly trillions in U.S. debt. Their purchases are oversubscribed by about 40%, meaning more investors want to sell U.S. Treasuries than the Fed is willing to buy. If the Fed’s purchases are oversubscribed, how will the U.S. Treasury be able to sell massive amounts of U.S. debt at auction in the future? The quick answer is they won’t be able to unless the Fed is willing to buy this debt, which of course, they are.
If you were the U.S. government and you were about to issue the most significant amount of debt in your country’s history, would you want interest rates to be low or high? The answer is, of course, as low as possible.
There are two ways for the Fed to keep rates as low as possible, and I think the Fed will ultimately implement both of them. First, they will purchase this debt in the secondary market with a wink and a nod to primary dealers. I say this tongue in cheek because if the Fed bought this debt directly from the U.S. Treasury, it would be called Modern Monetary Theory (MMT), and I don’t think the U.S. government wants to be painted with the MMT brush. At least not yet. Purchasing from primary dealers will make the optics better and make it look more business as usual. For their effort, the Fed will throw primary dealers a few basis points for their trouble. The graph below does a good job of depicting how the Fed will intervene.
I also think the Fed will have to control yields up and down the curve. They will let yields float but only to a point, and they will go no higher. The bottom line is that the Fed will do whatever it takes so that the U.S. Treasury has the proceeds it needs to fund the U.S. government. After watching the Fed’s interventions in March, you would be mistaken to think otherwise.
The U.S. Dollar Stays Strong
So how will large deficits affect the U.S. dollar? Typically when a country incurs larger deficits, it is inflationary because higher deficits decrease the value of the currency. A weaker currency means things cost more to buy, and inflation ensues. This situation is unique because most industrialized nations will also incur significant increases in their deficits, which will help to normalize deficit spending across much of the world.
The U.S. also has a get-out-of-jail-free card because the U.S. dollar is considered the world’s reserve currency. Meaning most worldwide financial transactions are conducted in U.S. dollars. Today, more than 61% of all foreign bank reserves are denominated in U.S. dollars. Approximately 40% of the world’s debt is denominated in U.S. dollars. Being the word’s reserve currency means there will always be a demand for U.S dollars.
The world has had an insatiable appetite for U.S. dollars during the Covid-19 crisis, causing the Fed to open up additional swap lines and flood the world with U.S. dollars. Flights-to-quality heightens the demand for U.S. dollars and gives the U.S. dollar a bid against most other currencies. This additional demand for U.S. dollars should help offset the downward pressure caused by larger U.S. deficits. World reserve currency status should help keep the dollar strong in the face of rising deficits, so inflation should be normalized.
Drowning Out The Noise
To drown out the noise, I would encourage you to consider the patient, which in this case is the U.S. Economy. Congress and the President will continue to pass stimulus legislation, but it will be up to the U.S. Treasury and Fed to make sure the U.S. government has the means to do its job at the lowest cost possible. As the issuer of the world’s reserve currency, they have house odds.
You are going to hear many talking heads rattle their sabers about inflation. You are going to hear arguments that world trade is going to decrease, causing the price of goods and services to increase. Another camp will state that the market can’t possibly handle the excess supply of U.S. Treasuries that is about to flood the market, which will cause the yield curve to steepen. You are also going to hear that too many dollars chasing too few goods will cause inflation. The arguments will be many, but in the end, the U.S. Treasury and the Federal Reserve will engineer a path forward that will enable the U.S. government to function in the most cost-effective way possible.
What Opening Up May Look Like
The state of Idaho just announced a careful four-phased approach to open up the state’s economy. The state of Idaho is following the lead of the CDC, so if your state hasn’t posted their guidelines, Idaho’s roadmap may give you some idea about what to expect in your state. Here is a link if you are interested https://rebound.idaho.gov/wp-content/uploads/2020/04/opening-up-guidlines.pdf. Each phase will last two weeks. If there are any setbacks, then the current phase will be extended by two more weeks, or we go back to the previous phase. If everything goes perfectly, the state will be fully open with no restrictions on June 27th. My oldest daughter Sarah is getting married to on July 8th, so she is hoping everything goes as planned.