Wednesday, February 17, 2010

US Deficit Management: Feeling in the dark

If there is anything that keeps stomach of the average US investor in a knot, it is the size of the US deficit. For all the story of US growth prospects, with the deficit always looming in the background, there is a feeling that whole system could fall to piece if this issue is neglected. The US deficit is huge. At this time of economic stress, it is important to ask if US at immediate risk? If not, what are some scenarios which could be a tipping point?

Right now, the US is not considered to be a major risk. The US has no problems rolling over their debt at any maturity. We don't know how long that will be so easy. Yet there are other countries with more immediate debt concerns that may be a canary in the coal mine.

Yet as the Economist notes above, the US one of the lowest average duration measures of all heavily indebted countries.

As a course of the recent stimulus financing, the US has been selling heavily into the middle of the medium term of the yield curve. This helps by lowering debt payments on debt rolled over. In fact, the US has actually reduced their interest payments in 2009 recently because of our focus on issuing debt in the 3yr to 7yr range of the yield curve.

Essentially is a leveraged bet on the future economic growth and fiscal management. If there is an econmic shock or significant inflation causing higher interest rates in a 2.5 to 6.5 year period, the rollover of the remaining debt will cause a marked increase in debt servicing payments. This is particularly of concern because the overall US debt schedule will be so focused on the front end of the yield curve causing a massive rollover of debt in just a few years.

Who knows if we will be ready, or just in worse shape from kicking the can down the road, when that time comes?

Scenarios that could cause US debt to become a noose....

1. China decreases consumption of US debt

If China reduces stimulus too fast it's accumulate such massive amounts of foreign currency and becomes a long term net seller of US debt instruments

2. Japan decreases consumption of US debt

If Japan faces a large deflationary spiral or exports do not recover, it must decrease purchases to amortize it's own debt

3. Oil producers decrease consumption of US debt

If a world wide economic slump causes the price of oil to drop, some major oil producers (Middle East, Russia) who also are responsible for purchasing 10% of US Treasury debt, decrease purchases and unload their holdings

Deficit hawks, doves, and peacocks can crow all they want about deficit reduction or increased deficit spending. The looming threat of a debt crisis will remain until there is a cultural transformation regarding fiscal management to reduce short term borrowing needs.

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