Currencies | Jun 05 2009
By Greg Peel
“I think he’ll fail at pulling a balanced rabbit out of a hat,” Bill Gross told Bloomberg this week in reference to US Treasury Secretary Geithner. “They are talking about – once the economy in the US renormalizes – the move back towards balance or much less of a deficit. I suspect that will be hard to do”.
Bill Gross is the founder of the world’s largest bond fund manager, Pacific Investment Management Co. (Pimco). FNArena readers who have been following the excellent The Ascent of Money series currently airing on the ABC will recognise Gross as the appropriately dubbed “Mister Bond”. With over US$800bn under management, when Gross speaks, the world listens. Pimco’s US$150bn flagship Total Return Fund returned 4.3% in 2008 – beating 93% of its peers.
Gross, like many others, is worried about the massive fiscal deficit the Obama Administration is planning to run in order to restimulate the US economy on the one hand, and affect significant policy changes on the other. The US government is now (including steps taken by the previous administration) a major shareholder in Fannie Mae and Freddie Mac, AIG, General Motors and Chrysler, and a minor shareholder in all of America’s major banks. The US was already in deep fiscal deficit even before the GFC began, and Obama intends to add policies such as universal health care and social security reform to the mix at a time when funding is hard to find.
Not that there’s anything wrong with that, but the administration plans to push the budget deficit to US$1.845 trillion in the year ending September. This will represent 12.9% of GDP, and Geithner’s intention is to pull that back to 3% as soon as possible. But as consumers back off from spending and the US economic growth rate slows, Gross believes such a target is overly ambitious.
To that end, Pimco is advising holders of US dollars to diversify before the central banks and sovereign wealth funds ultimately do, Bloomberg reports. If Gross is right, the subsequent slide in the US dollar will send long bonds yields higher and the price of US dollar-denominated commodities surging further and thus inflation will become a real problem. Enough of a problem that it would threaten to derail any attempted US economic recovery.
US Fed chairman Ben Bernanke also gave Congress a stern warning this week that everything must be done to bring the fiscal budget under control as soon as possible. Bernanke has not been a proponent of the inflation argument and is maintaining that stance, but for the first time he has publicly suggested inflation control will require a diligent government committed to deficit reduction.
Bernanke does not otherwise fear inflation, as while he continues to believe the US economy will bottom out in late 2009, he believes a return to average economic growth will be a long, slow process. The weight of private debt built up in the system in the past decade was enough to mean unwinding will take a long time as everyone from major banks to private households move to repair their balance sheets. The influence of debt unwinding is deflationary and will continue to be deflationary, which is why Bernanke has no qualms in committing the Fed to quantitative easing – the buying of US government-issued bonds – even though, if poorly managed, quantitative easing is one of the most inflationary policies possible outside of simply printing banknotes.
Despite the Fed making its quantitative easing intentions perfectly clear to all the world, the yield on the US 10-year bond has recently began to rise substantially, signifying inflation fear. Bernanke’s faith, if you like, in deflation means he is not too concerned by this recent move. But with the US Treasury preparing to auction another US$65bn of government bonds just next week, as part of the biggest ongoing public money raising exercise in US history, the fear is that buyers will not be found.
When the UK saw Standard & Poor’s relegate the AAA-rated British government to negative watch last month, Gross suggested the US would eventually lose its AAA rating altogether. This effectively means the US government would have to pay more for its funding as the world perceives US debt as a more risky investment. However, critics of the ratings agencies suggest (a) they have lost all credibility over the last two years anyway, and (b) how can the largest and most powerful economy in the world not have the highest relative rating? It makes little logical sense.
Yet Gross suggests that coupled with Obama’s planned health care and social security reforms, total US debt on issue could ultimately reach 300% of GDP. Even if China and other surplus nations wanted to, they could not fund a deficit of this size.
Despite all the fear, Bloomberg reports that Fed holdings of US Treasuries on behalf of central banks and foreign institutions – from China to Norway – are currently as high as they ever have been. Such holdings rose 3.3% in May – the third biggest jump on record.
There has also been much talk that the surplus nations will look to diversify out of US dollars by pushing a policy of replacing the dollar with a basket of currencies as reserve currency. There have been many off-hand comments coming from China and elsewhere, although on Wednesday Reuters reported the surplus nations had conceded they could never abandon the US dollar as reserve currency because there’s just nowhere else safe to go. Nevertheless, analysts will be watching closely when Russian president Medvedev meets with his Brazilian, Indian and Chinese counterparts this month.
Medvedev has also made comments about a new basket reserve currency, most recently in an interview with business network CNBC. Not unsurprisingly Medvedev would see the rouble as being part of such a basket, leading to some smirking from US analysts. The rouble is not known for its stability.
In the meantime, the stock market continues to trade on the hope of a global economic recovery anytime soon. As to how far such a rally can extend is another matter, given both deflation and high inflation threaten the attraction of stocks.
