A ballooning budget deficit combined with a rising current-account deficit are raising the odds the U.S. could suffer an emerging-markets-style debt crisis, analysts at Deutsche Bank warned this week.
To be sure, danger doesn’t appear imminent and the odds may even be overstated, but the risk is rising and shouldn’t be ignored, wrote Quinn Brody, macro strategist, and Torsten Slok, the bank’s chief economist, in a Wednesday note. Their model calculated that the probability of a U.S. debt crisis has increased by 7 percentage points, from a historical below 9% to around 16%.
A sovereign debt crisis occurs when a country is perceived as no longer able to meet its debt obligations. Brody and Slok note, however, that the U.S. has several obvious advantages that are often absent the typical emerging market economy. For one, the U.S. borrows only in its own currency, while the model they used includes countries that borrow abroad.
Also, the U.S. has room to raise additional revenues given its below- tax rate (26% of gross domestic product in 2016 versus the 34% for developed nations in the Organization for Economic Cooperation and Development). And perhaps most important of all, the U.S. dollar is the de facto global reserve currency, making up almost two-thirds of global official reserve assets, while one out of four dollars lent to the U.S. Treasury comes from the foreign official sector—institutions that need a safe, deep and liquid place to park their reserves.
“There are few alternatives to U.S. Treasurys in the size and scope of a safe asset demanded by global investors,” they noted.
Nevertheless, the question persists because while Treasurys have tended to rally during episodes of market stress, even when U.S. economic growth slowed sharply in 2008 or when China devalued its currency and signaled potential selling of its vast Treasury holdings in 2015, it isn’t happening now, Brody and Slok wrote. Indeed, that is why “investors need to pay attention to whether an EM—style debt crisis is about to play out.”
They urged investors to keep a close eye on Treasury auctions, they said. After all, trouble digesting rising U.S. debt issuance would be a first sign of trouble.
“Crises are usually characterized by a ‘sudden stop’ in financing,” Brody and Slok wrote. “Both fiscal and current account deficits require capital inflows, and declining foreign demand for Treasury securities might signal imminent pressures.”
They note that there are no major signs of such stress at present, but urged investors to monitor Treasury auctions for signs of declining external demand, something that will be particularly important in 2018 as the Treasury Department prepares to significantly increase the supply of government paper (see chart below) at the same time several “pillars of demand are likely to soften.”
The pillars they refer to include the Federal Reserve, which is shrinking its balance sheet, and foreign purchases, which are falling as the European Central Bank prepares to wind down its own quantitative easing program. The trends are evident in lower bid-to-cover ratios—the amount of total bids compared with the amount sold—which recently plumbed their lowest levels since the financial crisis, they said (see chart below).
In a separate email, Slok noted that the net supply of Treasurys is set to double over the next 18 months and that even if this doesn’t trigger a crisis, it’s clear that worries about future demand for U.S. Treasurys are part of the reason for the rise in long-term interest rates, which saw the 10-year Treasury yield TMUBMUSD10Y, -0.81% tick above 3% this week for the first time since early 2014.
That move was blamed at least in part for stock-market weakness earlier this week that sent the Dow Jones Industrial DJIA, -0.05% and S&P 500 SPX, +0.11% skidding. Major indexes were higher Thursday, while the 10-year Treasury yield moved back below 3%.
“The bottom line is that the bond vigilantes are slowly waking up after a decade in hibernation,” Slok said.