The United States has been debt-free in only two years of its existence, 1834-5. We experienced hyperinflation as a fledgling republic. The phrase “not worth a Continental” referred to the continental dollar used to finance the Revolutionary War, and not to a car manufactured by Ford Motor Company. We have also had deflation in double digits during the Depression era. Neither hyperinflation nor severe deflation is currently in the forecast horizon.
At a level of about $11.5 trillion, we are presently trending to a debt/GDP ratio of 85%. At the end of World War II that measure of debt burden peaked at 120%. If current trends of net new borrowing of over $100 billion a month continue, we are likely to exceed that wartime record. The annual interest burden is approaching a half a trillion dollars and grows as the debt ratio grows. This will intensify once higher interest rates occur.
In sum, the debt burden is large and growing. It may not be inflationary in the short term because of the recession. It will be inflationary in the longer term unless the Fed exits its massively stimulative strategy in a precisely executed process. History says central banks do not do these things with precision. That means there is a high risk of a policy failure, because the Fed may either move too soon or wait too long. Members of the Fed are required to operate with forecasts. And they, too, are human.
On this birthday weekend, one in ten workers is looking for a job and cannot find one. One in six is underemployed, which means many have some job but at much less income than in their previous experience. The average hourly work week is stagnant. While the unemployment rate is a lagging indicator, the work week is a contemporaneous one. It will have to rise in order for things to start improving. So will measures of labor income. Neither is happening, so the turnaround is not yet at hand.
In a provocative research comment on July 3, 2009, David Woo of Barclays Capital uses three data series to derive a model of the impact of the growing federal deficits on the US dollar/euro exchange rate (EUR/USD). He ends with a forecast that a “5% increase in the outstanding stock of US Treasuries relative to eurozone government bonds is associated with an 8% depreciation of the USD on average.” Woo studied the period of 1999 to present. The euro started its trading existence on January 1, 1999.
Woo also notes that low “substitutability between eurozone government bonds and Treasuries” is indicative of a market now driven by “central banks” and government institutions. That means interest rate differentials between these two groups are now a less powerful factor in determining the outcome of the EUR/USD exchange rate. His math supports this conclusion and suggests the forthcoming and ongoing large US federal deficits will weaken the US dollar. Woo’s one-year forecast is for a EUR/USD exchange rate of 1.50.
Impressive within Woo’s work is how he estimated the temporary effect of a flight to quality into the US dollar. He used the VIX as a measure to determine when the spread between eurozone government bond yields and Treasury yields widened during crisis response periods. The VIX effect is temporary but powerful when it happens. A VIX spike can result in a dollar rally and lower Treasury yields, which seems counterintuitive to many market agents. Markets may want to pay close attention to this measure offered by Woo, since it is the longer-term trend that prevails.
Since we believe the outlook for US fiscal policy is bleak for the next decade, we extended Woo’s work beyond his one-year time horizon. We accepted the Congressional Budget Office estimate that the annual Obama deficits will exceed $1 trillion for the next ten years. In fact, we expect that the cumulative deficit will be higher than the CBO estimates, because we believe that our political system is currently heavily biased towards borrowing instead of taxation. Those assumptions lead us to a 1.60 to 1.70 EUR/USD in the early part of the next decade and a longer-term level of 2.0 or higher as the decade progresses.
