Deficits Do Matter

Government debt is swelling so fast, the Fed's bond purchases can't keep up...

ALL SORTS OF MISCHIEF is afoot in the financial markets, writes Dan Denning in his Australian Daily Reckoning.

US stocks fell over 1.5% in Thursday trading. The minutes of the Federal Reserve's April meeting were published, stating "significant downside risks" to the US economy and that the global financial system remains "vulnerable to further shocks."

You don't say?

The minutes also showed the Fed is willing to print more money to buy more bonds in order to keep US interest (and mortgage rates) low. This, by the way, is spurring the trade out of financial assets and into real assets, such as Gold Bullion. The Fed has already purchased $450 billion in mortgage backed securities to keep the flow of credit going to the US housing market. It's also purchased $79 billion in bonds issued by government sponsored enterprises Fannie Mae and Freddie Mac.

What would you expect to happen if the central bank of the world's largest economy reduces its growth forecast and says it is willing to step into the bond market to "support the recovery" by keeping yields low?

Check out the chart below, sourced from the Wall Street Journal...

When the Fed first announced its intention to buy mortgage-backed bonds and Treasuries in November of last year, it sent yields on ten-year US notes and 30-year bonds tumbling.

Traders and banks front-ran the Fed and got in ahead of the Fed buying, which they expected to push up prices. But by the time 2009 began, the Fed buying (or threat of buying) was no longer enough to keep yields low. They've been climbing ever since.

This Thursday, even after the meeting notes revealed the Fed might go beyond spending $1.75 trillion on Treasuries and mortgage-backed securities, ten-year and 30-year yields moved up again. (The interest-rate on T-bonds is fixed, of course, so yields offered to new buyers move inversely to prices.) And as T-bond yields rose, so by the way did the Gold Price and crude oil.

Why? The Fed is losing control of bond yields. It's going to have to wade in with trillions more. That will push up commodity prices. What's happening here is not exactly clear, but it sure looks to us like the Fed's indication that it's willing to ramp up purchases of US assets to keep rates low is actually causing investors to sell US assets.

Investors are beginning to wonder what the inflationary effects of such a large money-printing campaign might be, and what it would do to the value of their existing bonds and notes. This is one reason why the largest holder of publicly traded US debt (China) has shifted its purchasing of US debt to the short-end of the yield curve.

The good news for the big spending American government is that its creditors are willing to finance its deficits. The bad news is that those deficits are now a lot more interest rate sensitive. If shorter-term yields start trending up along with the longer-term yields, it's going to get really expensive for America to borrow.

Do you sense a theme here? Deficits DO matter.

The other big news on the day was that Standard and Poor's announced it could cut Britain's credit rating from Triple A on account of that nation's massive deficits. It moved Britain's rating from "stable" to "negative." Ireland, Greece, Portugal, and Spain have already lost their Triple A ratings because of massive fiscal deficits. But Britain is beginning to cause a lot anxiety in global bond and currency markets.

The UK – already deep into Quantitative Easing, just like the Fed – is going to run a £175 billion fiscal deficit this year alone. That's 12.5% of GDP. It will need to sell £220 billion in bonds to cover the gap. And mind you, it's a big gap. The nation's total debt is nearing 100% of GDP.

The government deficit was £8.5 billion in April alone. That was the highest monthly deficit since 1993. And it speaks to a point we made earlier this week that once a government debt-to-GDP ratio reaches 10% and beyond, it begins to drag on GDP growth and lead to even higher deficits (lower tax takings, higher debt-servicing costs). Pimco's Bill Gross went on Bloomberg television and said markets are, "beginning to anticipate the possibility" that the US will face a similar credit downgrading.

Let's recap. Stocks are down. British gilts are down. US bonds are down. And both the pound and the US Dollar were weaker against other currencies.

Who says deficits don't matter?