Summary
- Our analysis provides kind of a Grand Unified Theory (GUT) of what is currently taking place in global financial markets
- The massive borrowing by the U.S. Treasury is crowding out emerging markets capital flows
- The structural factors that have kept long-term interest rates low and term premia repressed are fading
- We expect a measured move in the 10-year Treasury yield to 4.25 to 4.40 percent, much sooner than the market anticipates
“Reagan proved deficits don’t matter.” – Dick Cheney
Memo to Dick Cheney:
- Deficits and the public debt are starting to matter. Really.
- It is now more strikingly true than ever given the U.S. public debt-to-GDP is more than 3.4x higher than when President Reagan took office.
Emerging Market Debacle
Go no further than the debacle currently taking place in the emerging markets (EM), which began in the second quarter of this year, to witness the consequences of the U.S. Treasury’s trillion-dollar-plus demand shock for global funding.
In a closed financial system and a non-QE world, price (interest rates) would adjust to move the capital and debt markets back to a more sustainable equilibrium. The rise in interest rates would force the government to borrow less as higher interest rates crowd out other spending. Also, the supply of loanable funds to the government would rise as savings increase.
That is not the world we now inhabit, however, where global financial repression by central banks has resulted in a “rent control” like shortage of dollar funding. The shortfall is now being plugged, in part, by the residual capital flows, which had been chasing yield in the emerging markets over the past several years.
That is the sucking sound you have heard since late April.
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