Tag: Fiscal Deficits

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The long game: The Dollar, Gold and US Treasuries

In the short term, the Fed and US Treasury manipulate the Dollar and US Treasury yields in an attempt to stimulate the economy while avoiding inflation. Foreign central banks also attempt to manipulate the Dollar to gain a trade advantage, which impacts the Treasury market. However, in the long term, large secular trends lasting several decades will likely determine the direction of US financial markets and fuel a bull market for gold.

Short-term Outlook

Inflation has moderated, with CPI falling below 3.0%, allowing the Fed to cut interest rates. The fall in headline CPI (red, right-hand scale) was precipitated by a sharp decline in energy prices (orange, left-hand scale).

CPI & Energy CPI

However, inflation could rebound if geopolitical tensions restrict supply or demand grows due to an economic recovery in China and Europe or further expansion in the US.

The Fed has cut its interest rate target by 1.0% from its 2024 peak to stimulate economic activity.

Fed Funds Target Rate: Mid-point

Efforts to normalize monetary policy have reduced Fed holdings of Treasury and mortgage-backed securities by $2 trillion. This would typically contract liquidity, stressing financial markets.

Fed Holdings of Treasuries & Mortgage-backed Securities (MBS)

However, the Fed neutralized its QT operations by reducing overnight reverse repo (RRP) liabilities by nearly $2.3 trillion. Money market funds were encouraged to invest in the enormous flood of T-bills issued by Janet Yellen at the US Treasury instead of in reverse repo from the Fed. The simultaneous reduction in UST assets and RRP liabilities on the Fed’s balance sheet left financial market liquidity unscathed.

Fed Reverse Repo Operations

Long-term Treasury yields climbed despite the Fed reducing short-term rates, indicating bond market fears of an inflation rebound. However, a benign December reading for services CPI (below) triggered a retracement.

CPI & Services CPI

Respect of support at 4.5% will likely signal an advance to test resistance at 5.0% on the 10-year Treasury yield below.

10-Year Treasury Yield

The Dollar Index found support at 109 and is expected to re-test resistance at 110. The strong Dollar increases pressure on foreign central banks to sell off reserves to defend their currencies, driving up yields as foreign selling of Treasuries grows.

Dollar Index

Gold is trending upwards despite rising Treasury yields and the strong Dollar. Breakout above $2,800 per ounce would offer a medium-term target of $3,000.

Spot Gold

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The Long Game

The elephant in the room is US federal debt, which had grown to $35.5 trillion at the end of Q3 in 2024.

Federal Debt

Fiscal deficits are widening, with interest servicing costs recently overtaking defense spending in the budget.

CBO Projected Federal Deficit

Federal debt (red below) is growing faster than GDP (blue), warning that the fiscal position is unsustainable, especially as interest servicing costs widen the gap.

Federal Debt & GDP Growth

The ratio of federal debt to GDP grew to a precarious 113.3 percent at the end of Q3 2024 and is expected to accelerate higher.

Federal Debt to GDP Ratio

Long-term Treasury yields are rising as concerns grow over the unsustainability of debt and deep fiscal deficits fueling long-term inflation.

10-Year Treasury Yield

The strong Dollar further exacerbates the situation, increasing sales of US Treasuries, as mentioned earlier, when foreign central banks free up reserves to protect their currencies. The incoming Republican administration has committed to preserving the Dollar’s status as the global reserve currency. Maintaining reserve currency status is likely to entrench a strong Dollar. A Dollar index breakout above 110 will offer a target of the high at 120 from 2000, as shown on the quarterly chart below.

Dollar Index

As Luke Gromen points out, the Fed can cut interest rates to weaken the Dollar, but that would increase fears of inflation and, in turn, drive up Treasury yields. So, the rise in long-term Treasury yields is almost inevitable.

Gold respected support at $2,600 per ounce, as shown on the monthly chart below. The secular uptrend is fueled by four key concerns. First is the sustainability of US federal debt. Next is fear of rising inflation exacerbated by the on-shoring of critical supply chains and a decline in international trade. Third are geopolitical tensions, fostering rising demand for the safety of gold and an increased desire by non-aligned nations to break free from Dollar hegemony. Last is the collapsing Chinese real estate market, which no longer serves as the primary investment for private savings, leaving gold the most attractive alternative.

Spot Gold

Breakout above $2,800 would offer a long-term target of $3,600 per ounce.

Conclusion

Treasury yields are in a secular uptrend, with the bond bear market expected to last at least a decade. The primary driver is concern over the sustainability of US federal debt, which exceeds 110% of GDP, while deficits threaten to expand. Not far behind are fears of rising long-term inflation, fueled by expanding fiscal deficits while the economy is close to full employment, and increased protectionism driving up costs.

The Dollar is likely to remain strong, with the Index expected to reach 120, as long as the US remains committed to preserving the Dollar’s status as the global reserve currency.

Gold is riding a secular wave, fueled by concerns over the sustainability of US federal debt, fears of long-term inflation, rising geopolitical tensions, and collapse of the domestic real estate market as an attractive investment for private Chinese savings. We expect this to last for decades, perhaps even longer. Our target for gold is $3,600 per ounce by 2028.

The only feasible long-term path to reduce federal debt relative to GDP is for the Fed to suppress interest rates. This would allow GDP fueled by inflation to grow at a faster rate than fiscal debt and gradually reduce the ratio of debt to GDP to sustainable levels. The inevitable negative real interest rates would further boost demand for gold.

Acknowledgments

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Australian Outlook | Chris Joye

Central banks are too much under the sway of government and not doing enough to contain inflation. None worse than the RBA which is holding rates lower than they should be. The last time that we had inflation at 4.0% in 2008, the cash rate was 7.25%. Now the cash rate is only 4.35%.

RBNZ is far more independent and hiked their official cash rate to 5.5%. The NZ economy is in recession but they still face the threat of stagflation, with low growth and high inflation.

In Australia we have a negative output gap, where demand exceeds production capacity, far worse than in most other major economies. The only solution is to raise unemployment to lower demand. But RBA governor Michelle Bullock has publicly stated that the RBA is not looking to reduce employment.

The latest Australian government budget is highly stimulatory and likely to fuel further inflation.

The outcome is likely to be long-term inflation and higher long-term interest rates.

Conclusion

We expect strong inflationary pressures in the next decade as governments run large fiscal deficits. Additional government spending is needed to:

  1. Address the energy transition from fossil fuels to renewables and nuclear;
  2. On-shore critical supply chains; and
  3. Increase defense spending in response to geopolitical tensions.

Long-term interest rates are expected to rise over the next decade, fueled by higher inflation.

Central banks may attempt to suppress interest rates by further expanding their balance sheets to buy long-term fiscal debt but that is short-sighted. Inflation would accelerate even higher.

Apart from the hardship to wage-earners, and the subsequent political chaos, high inflation would threaten bond market stability. Bond market investors would be reluctant to fund deficits when interest earned is below the inflation rate. Unless there are no alternatives.

That is why the long-term outlook for gold and silver is so bullish.

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Long-term outlook: How does it all end?

What economic path are the US and major allies likely to take over the next decade? Here is my take on how this is likely to pan out.

First, let’s start with a template of what a healthy, growing economy looks like.

A Virtuous Cycle

Growth is dependent on two factors:

  • Demographics — that is a growing, skilled workforce; and
  • Productivity — where output grows at a faster rate than the workforce.

Growth requires not only a growing population but a growing workforce. An ageing population or large population under the age of 25 is unlikely to contribute much to output. What is needed are people of 25 to 55 who hold down productive jobs. We also need to ensure that they have the necessary skills — productivity tends to rise with education levels. Education that is skills-based is worth a lot more than a barista with a bachelors degree.

The most important source of productivity growth, however, is investment. More specifically, private investment — government investment tends to provide a short-term boost to the economy but acts as a long-term drag on growth (Dr Lacy Hunt). Mechanization and automation increase the output per worker, boosting productivity.

The chart below shows US private domestic non-residential investment (blue) at a healthy 13.5% of GDP, while productivity (magenta), calculated as real GDP/total non-farm employees, has grown steadily since the 1950s.

Private Investment/GDP & Real GDP/Total Non-farm Payroll

Savings are needed to fund private investment. Either domestic savings or offshore borrowings. Domestic savings are better than foreign debt, especially if debt is denominated in a second currency which can cause volatile short-term capital flows. Workers tend to consume what they earn, with low rates of savings, while the wealthy tend to have far higher savings rates. High levels of inequality increases the amount of saving but depresses consumption. Low consumption leads to fewer investment opportunities, so it is important to get the balance right. Forcing workers to save (e.g. through compulsory superannuation) is one solution.

Low deficits are essential to ensure that government borrowing does not crowd out private investment. Government investment — as we mentioned earlier — is no substitute for private investment as it leads to low productivity and low growth.

Monetary policy is often used to prime the pump — stimulating consumption and investment through low interest rates. But cheap debt has short-term benefits and long-term costs that are often not carefully considered. First, low interest rates discourage private savings which are the lifeblood of a healthy economy. Second, low interest rates are effected by the Fed (or central bank) growing the supply of money at a faster rate than output (GDP). But that causes inflation after a lag of one to two years, forcing the Fed to contract the supply of money and destabilize growth. Third, cheap debt and high inflation (with negative real interest rates) encourage malinvestment in speculative assets that are expected to grow in price without necessarily growing output. The net result is that productive investment is crowded out by both malinvestment (speculation) and government deficits, harming long-term growth.

There is also a fourth, far more insidious factor, that operates with much greater lags. Home prices tend to grow at a much faster rate than incomes during times of low interest rates, reducing access to homes by younger workers entering the workforce. New household formation slows and so does the birth rate, undermining long-term demographics. This can be remedied to some extent by skilled immigration but often migrants are unskilled and face both language and cultural challenges that lead to poor assimilation and a two-tier economy.

In summary, what is needed is a growing, skilled workforce with rising productivity from healthy private investment. Private investment requires stable growth — to facilitate reliable projections rather than unstable boom-bust cycles — and sufficient funding from private saving. Government deficits need to be kept low and real interest rates reasonably high (say 3%) to ensure low inflation and encourage efficient allocation of capital (to productive private investment).

In the Wilderness

We are a long way from the above ideal.

The chart below shows the decline in 10-year average real GDP growth, since 1960, and rising debt relative to nominal GDP.

Total Debt/GDP & Real GDP Growth

Growth is slowing due to poor demographics, rising government deficits, and malinvestment from negative real interest rates. Geopolitical tensions and the need to secure supply chains and sources of energy mean that government spending is likely to exceed tax revenues by a wide margin for the foreseeable future.

Ballooning government debt is likely to crowd out private investment, ensuring low future growth. The chart below shows CBO projections of debt-to-GDP for the next thirty years.

CBO Projection of Debt/GDP

The Fed will likely have no choice but to suppress long-term interest rates in order to assist government in servicing the massive interest burden on its debt. That is likely to lead to high inflation, negative real interest rates, malinvestment in speculative assets, low growth, and rising instability (Hyman Minsky).

Conclusion

We are likely to face a decade of stagflation, with low growth, high inflation and unstable financial markets.

Hopefully, inflation will boost nominal GDP relative to government debt, increasing serviceability, over time. That would provide an opportunity to reduce fiscal deficits and establish healthy monetary policy.

In the meantime, don’t fight the Fed. When interest rates are low and inflation is high, invest in real assets. Look for value — with stable income streams which can withstand tempestuous cycles — rather than speculative growth.

Acknowledgements

Professor Percy Allan, University of Technology Sydney: Looking Beyond 2024

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