A viable alternative to investing in the US

The European Union (EU) is discussing plans to issue pan-European sovereign debt to centralise the work being done by respective EU members’ central banks. The EU Recovery Fund (the Fund) will effectively monetise EU governments’ borrowings used to fund fiscal spending to combat the COVID-19 pandemic.

The plan is for the Fund to be of a sufficient magnitude so it can support the most affected EU sectors and geographical parts and avoid a prolonged 1930s style depression. The proposal is to gear up the Fund to create a borrowing programme of at least EUR1 trillion.

As with any decision by the EU, there is considerable debate over how the fund should operate, in particular whether it should provide loans or grants. The hardest hit countries such as Italy and Spain would like to receive the assistance as grants, or direct money transfers, but the more fiscally disciplined members such as the Netherlands, Austria and Germany seemingly prefer loans, albeit it at low interest rates. Either way, the Fund will borrow from financial markets for its assistance to member nations.

Almost all media reporting and comment has been on political debate within the EU, and on the form and amount of assistance to troubled EU members. I have not seen any comment on the Fund’s borrowing programme despite its immense implications for financial markets. It seems logical that the Fund will offer debt that is guaranteed joint and severally by all EU members. That would put the Fund’s debt on par with US Government debt, as a risk free sovereign guaranteed investment.

The key attraction of US Government debt has been as a risk free investment in the world’s reserve and trade currency. Investors, especially sovereign nations through their central bank or wealth funds wanting to diversify away from US Government debt, lack an alternative liquid, plentiful prime risk-free investment.

The gap between the yield on 10 year US Treasuries and German bunds is more than 100 basis points (1.00%), which is at odds with US Treasuries’ status as the world’s prime risk free investment because investors are demanding a 1.00% higher return from US Government bonds compared to German Government bonds over the next 10 years.

The Fund could provide a powerful alternative, especially if the world decides that the yields offered by US Government debt no longer compensates for the US’ risk.

Given the current strained relationship between China and the US, notably on matters of trade and coronavirus, the US should be worried that one of the largest holders of US Government debt could be tempted to put a chunk of its money somewhere else. Especially if that somewhere else is of equal risk and geopolitical importance. Where China’s money goes, others will follow.

Is the strong US dollar merely the Emperor’s new clothes?

One noteworthy feature of financial markets this month has been the rush to buy the US dollar. This has me puzzled.

At times of economic and fiscal stress and uncertainty, investors shift from demanding a return ON capital to demanding a return OF capital. Yet, they are rushing to buy US dollars, hoping for a return OF capital! If the US dollar is so strong despite such poor US fiscal, economic, social and political outlooks in a post-coronavirus environment, how bad is the rest of the world?

Prior to the outbreak of COVID-19, the risk-reward balance of the US economy favoured the reward.

  • The US was reporting economic growth (as measured by GDP) and offered interest rates higher than other main economies, except for China; the US is the world’s largest economy;
  • the US dollar is the world’s main reserve currency at a macro level (government, trade and debt) and micro level (it is estimated that more than 40% of US cash on issue is outside the US, fuelling the global black market);
  • almost all commodities are traded in US dollars;
  • the US is on track for an eye-watering USD1 trillion deficit this fiscal year (before any emergency fiscal packages);
  • the US Government is the world’s largest borrower; and
  • US companies have geared up their balance sheets in recent years to take advantage of ‘cheap’ debt (so, there’s lots of securities for investors).

The latter three highlight the US’ main risk and vulnerability, more so if you consider the implications for the substantial increased supply of US debt and US dollars. The US federal government (as well as state governments and municipalities) will have to issue more debt to fund their stimulus packages. There is no urgency for investors to buy US debt (both public and private sector). They can hang back and wait for higher interest rates.

To help fund the increased US government debt, the Federal Reserve has indicated that it will undertake more quantitative easing, i.e. it will print money to buy the government’s debt, thereby increasing the supply of US dollars. All things being equal, more US dollars in circulation will lower its relative value.

The US’ response to the coronavirus threat (at federal and state levels) has lacked a cohesive plan. With on or two exceptions at state and local levels, officials seem reluctant to adopt the hard-line public health measures that have been adopted elsewhere (e.g. China, Italy, France, UK, Singapore, South Korea, Australia and New Zealand). As a consequence, the US has fallen behind its major trading partners in addressing the health threat and economic fallout from COVID-19. Furthermore, the US can only fund any fiscal support by issuing even more debt, which puts it under even more obligation to investors and shifts the risk-reward balance towards risk.

Many US companies have increased their debt levels and overall leverage in recent years by taking advantage of low interest rates and easy credit conditions but that has made them vulnerable to the sort of dire economic outcome that many see in a post-coronavirus US. The recent, dramatic fall in US stockmarkets is an understandable adjustment to the risk-reward balance given many companies’ prospects for reduced future earnings and the need to feed higher gearing.

Again, I ask – why buy US dollars?

I expect that the recent rush into US dollars has been defensive – to acquire USD cash for future US dollar denominated spending and debt commitments. Some of those buying US dollars internationally are US based investors, such as mutual funds and those who manage the retirement and other savings of the ordinary US residents. However, many are foreign nationals investing through their central banks or sovereign wealth funds whose natural investment is not the US dollar.

Looking at this another way – the US is the Emperor and financial markets are its tailors who need to keep supplying the Emperor with new clothes even though all that the tailors have left are rags and their silver tongues. Eventually, the world will see the harsh reality of the Emperor’s new clothes, or lack thereof. Market prices (specifically, companies’ share prices, yields on US government and corporate bonds, corporate credit margins and the value of the US dollar) will then adjust for the US’ increased risk and savers will want their funds returned to the safety of home.

A country’s exchange rate against those of the main global currencies and its main trading partners is a major indicator of expectations for that country’s economic, fiscal, social and political performances, much the same way as a company’s share price is the major indicator of its activity, profitability and long term health. So, can someone please enlighten me as to why the US dollar has strengthened, why so many see the US dollar as a safe haven and why so many market economists and commentators are confidently predicting further US dollar strength?