US current account deficit will narrow and possibly move to surplus as US energy production and net imports decrease.
Accelerating US economic growth will lead to gradual rate normalization. Coupled with less global dollar liquidity and a smaller US current account deficit, the fundamental underpin for the global ‘carry’ yield trade will become progressively less favourable.
These dynamics will attract capital flows back to the US, supporting sustained US Dollar bull market.
We expect annual US growth to outperform current consensus expectations in the coming years. Significantly, we expect the official unemployment rate to decline fairly sharply during 2014 and 2015. In addition, revised estimates from the Congressional Budget Office (CBO), show that the US fiscal deficit is expected to average around 3% of GDP this year and possibly less in 2015, while remaining below 4% until the end of the decade. The projections are based on median growth of 3%, which suggests scope for a further improved revision in the event of growth averaging more than 3% in coming years.
The US current account deficit is also expected to narrow further in coming years, possibly below 1% of GDP, mainly due to surging oil production. When factoring in the potential for LNG and NGL exports, a cursory analysis also suggests that the US could, in fact, become a net energy exporter as early as 2017, well ahead of current consensus expectations.
If this dynamic proves true, there is the potential for the US to, in fact, run a current account surplus in the future, with significant global liquidity implications. In the post World War 2 era, the US has been an important source of global liquidity, and most obviously the only source of global US Dollar liquidity. During periods in which the US has run large current account deficits, it has acted as a substantial source of global liquidity, typically also resulting in a weaker US Dollar.
The infusion of US Dollars into the global monetary system in turn leads to lower interest rates globally, as the currencies of recipient countries typically appreciate. Lower interest rates and large capital inflows often lead to typical boom/bust dynamics in these recipient countries. The most recent example of such a dynamic was the Asian tigers in the 1990s and the subsequent 1997 and 1998 Asian financial crisis.
In the past decade, however, the largest beneficiary of US monetary policy, and the large current account deficit in place during the 2000’s, has been the newly emerging nations or so-called BRIC nations, and more specifically China. These countries also intervened substantially in order to prevent their currencies from appreciating. This policy invariably forced the respective Central Banks of these countries to aggressively purchase US Dollars by selling their own currencies, and thus investing in US treasuries. The chart below shows that foreign central banks went from owning around 15% of all US treasuries in the 1990’s to more than 40% at present.
This dynamic helped support the US Dollar and also helped keep US long-term interest rates below what could be considered fair value and thus, global rates by implication.
As we have discussed, market interest rates have been suppressed by large foreign Central Bank purchases of US securities, further complimented over the past four years by large-scale purchases by the Federal Reserve itself, driven by Quantitative Easing. This dynamic coupled with Central Bank policy targeting a zero short-term policy rate, has created what we may call ‘The Great Distortion’ of our time, most vividly reflected in the large wave of capital ‘searching for yield’. The suppression in the risk-free rate used as a key benchmark for pricing capital has invariably led to most yield-baring asset classes becoming extremely overvalued. This is most notably evident in high-yield corporate and emerging-market bonds.
The chart above shows the substantial inflows into these asset classes since the end of the financial crisis. This dynamic has also led to the market valuations of stable dividend-paying multi-nationals becoming substantially overvalued, especially relative to their growth prospects.
The simultaneous end of the Federal Reserve’s Quantitative Easing program (likely in 2014), and the narrowing of the US current account deficit will substantially reduce demand for US treasuries from the official sector. However, another source of important demand for higher-yielding securities has come from the financial sector, such as asset managers, hedge funds etc. They have sought to profit from the carry differential between borrowing in US Dollars cheaply, and using the proceeds to purchase higher yielding instruments and securities. Although difficult to establish, a large portion of the inflows, as reflected in the chart above, may have come from the so-called ‘carry trade’.
The funding sourced to establish these ‘carry trades’ is often ultimately underpinned by funding from the repo markets, where the primary collateral used is US treasuries. Ironically, the suppression of global interest rates by policymakers has created a powerful pro-cyclical dynamic, where the consequent ‘search for yield’ creates additional demand for US treasuries which are to be used as collateral in the repo funding markets in order to establish these carry trades.
Given the large inflows into these asset classes, and to the extent that they have been funded by cheaper borrowings, obviously creates a significant risk of a disorderly unwinding at some point in time. This dynamic is especially important given that so much of the total stock of US treasuries is now held by the official sector. This has created a collateral shortage at times, reflected in so-called failed repo trades, where the counter-party fails to deliver the repo security.
A sudden spike in the cost of repo funding, if the collateral shortage becomes acute, could indeed create just such a risk. This risk has become particularly relevant given new legislation which has reduced the ability of large financial institutions to carry large amounts of fixed-income securities on their balance sheet. The chart below shows that one of the intended consequences of the combination of Central Bank policy and new banking legislation, has been to create a substantial divergence between the substantial value of funds invested in high-yield ETFs relative to ‘dealer inventories’.
Ironically, the unwind of the carry trade due to an acute collateral shortage would probably, albeit temporarily, further depress long-term government bond yields as a flight to safety.
However, irrespective of how the trade will unwind, unwind it will. The gradual normalization of US interest rate policy will reduce the incentive for market participants to establish these carry trades or continue allocating capital into yield-bearing asset classes. The demand demand for US treasuries from the official sector will be greatly reduced due to no QE and a narrower US current account deficit. The prospect of a sharp and sustained rise in long-term interest rates over the next decade thus appears very likely and in contrast to the general consensus that exists today. Furthermore, longer-term market rates may also ultimately be pushed higher as inflation rates in the global economy start to accelerate. We believe this dynamic may become more of a risk factor over the next five years than has been the case over the past ten, and plays a core underpin for another of our major investment themes at present.Tags: US, USD