Source: Jin10 Data

Former New York Fed Chair, Bill Dudley, Chairman of the Bretton Woods Committee and Non-Executive Director of Swiss Bank, wrote on Wednesday that the real concern of the huge US budget deficit is not its direct impact on the currency market, but the possibility that the bond market vigilantes may wake up again. The full text is as follows.

The fiscal situation of the US government continues to deteriorate. According to the latest forecast from the Congressional Budget Office, the government will need to borrow an additional $400 billion this year to offset the budget deficit, and will need to borrow trillions of dollars over the next decade.

Investors have good reasons to worry about this trend, but it is not one of the reasons why the currency market is affected directly.

The forecast from the Congressional Budget Office does indeed present a bleak picture. It has raised the estimated fiscal deficit for 2024 from $15 trillion to $19 trillion, citing military aid to Israel and Ukraine, student loan relief, and higher interest rates. It estimates that the total deficit over the next decade will reach $22.1 trillion, higher than the estimated $20 trillion in February - this is based on the optimistic assumption that Congress will not extend the provisions of the 2017 Tax Cuts and Jobs Act beyond 2025.

Further increases in the deficit demand borrowing more funds. When the US Treasury unexpectedly needs to issue more debt, it typically does so by selling short-term Treasury bills, and if borrowing continues to increase, it can roll over short-term Treasury bills into long-term bonds. This raises concerns that a large amount of Treasury bills will hit the market, absorb cash, and trigger a surge in short-term interest rates, like the one that shook the currency market in September 2019.

I don't think that increasing Treasury borrowing will cause too much damage for three reasons.

First, higher-yielding Treasury bills will absorb most of the cash currently parked in the Fed's reverse repo purchase mechanism, where investors (mainly money market mutual funds) have lent around $380 billion against US Treasuries, with yields of 5.30%. As the use of this tool decreases, this cash will eventually flow into banks, increasing their reserves and reducing their demand for short-term borrowing.

Second, the Fed is very careful to ensure that banks have sufficient reserves to meet their liquidity needs, precisely to avoid a repeat of the turbulence in 2019. For example, this month the Fed slowed the reduction of its holdings of US Treasuries from $60 billion per month to $25 billion per month. All other things equal, the more bonds in the Fed's portfolio, the more cash reserves banks will have.

Third, the Fed now has a standing repo facility, also as a response to the turbulence in 2019. This ensures that banks can borrow cash against their holdings of US Treasuries at any time, at a current rate of 5.50% - effectively capping short-term rates, even if demand for cash unexpectedly exceeded banks' reserves.

So everything looks good, and there is nothing to worry about, is there? Of course not. The long-standing huge fiscal deficit in the US poses a huge risk. The more borrowing, the greater the likelihood of falling into a vicious cycle, and government debt and interest rates will inevitably push each other up. The growing burden of debt increases the pressure on the Fed to allow inflation to rise to dilute the debt - President Trump's re-election may facilitate this outcome.

We cannot know when investors will deem this risk too great to bear, as the so-called bond vigilantes did in the 1990s. And such events, once they occur, are often sudden and brutal. This is the most important issue.

Editor/Lambor