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On Latest US & Canada Tiff & Latin America’s Warsh Woes
The inability of President Donald Trump and Canada’s Prime Minister Mark Carney to play nicely resulted in the US placing 50% tariffs on certain Canadian imports. The move risks exacerbating US inflation, making Fed Chair Warsh’s job tougher, William writes. It also won’t help Canada solve its productivity problem. … Fed Chair Warsh’s hawkish Jackson Hole speech triggered selling in Latin American currencies. Higher US interest rates and a stronger dollar pressure nations with heavy dollar-denominated debt loads and commodity imports. William lists Latin American countries to watch. … And: the EM Latin America MSCI index may have a low earnings multiple, but analysts are very optimistic about future earnings growth. Toby examines the discrepancy.
Is A Debt Crisis Imminent?
"You are going to see a crack in the bond market, OK?" JPMorgan CEO Jamie Dimon said in a May 30 speech at the Reagan National Economic Forum. The US government debt situation is "nearing the point of no return" and approaching a "death spiral" that could threaten the stability of the world's largest economy, Ray Dalio writes in his new book "How Countries Go Broke: The Big Cycle," published June 3. Dimon and Dalio are smart and influential. We share their concerns. However, anyone who has followed their consistently pessimistic outlook over the past few years has missed a huge rally in the stock market. As for us, we'll worry about the government's debt when the Bond Vigilantes do. If a debt crisis is coming, we should make as much money as we can in stocks and sell just before the crisis hits. The question is whether the crisis is imminent. Even more important is whether a policy response could stop the crisis from turning into a death spiral. If so, the crisis will be a buying opportunity. The Bond Vigilantes have been stirring lately, but the 10-year Treasury bond yield remains between 4.00% and 5.00%. We've contended that this range is the "old normal," i.e., the same range as in the years from before the Great Financial Crisis to the Great Virus Crisis (chart). This suggests the economy is back to normal and growing at a solid pace. As we explained in our Bond Vigilantes Primer, the Bond Vigilantes tend to be on the loose when the 10-year US Treasury bond yield exceeds nominal GDP (chart). The yield is currently well below nominal GDP. US debt levels are undoubtedly concerning. Total public debt surpassed $40 trillion in August, roughly double what it was a decade ago (chart). However, about $7.7 trillion consists of intragovernmental debt, or money the government owes to itself. Because it is not traded in public markets, it does not directly affect the supply of Treasuries. Servicing the national debt is becoming a growing fiscal challenge. Treasury net interest outlays has climbed above $1 trillion on a 12-month basis, putting it on par with national defense spending (chart). The recent rise in the yield curve, along with mounting debt, will push net interest outlays higher. There is no way to put lipstick on this pig. Federal spending continues to rise relentlessly. CBO projections show total outlays exceeding $11 trillion over the next 10 years, driven primarily by mandatory spending and rising interest costs (chart). CBO projections also show annual budget deficits widening from about $1.8 trillion today to more than $3 trillion towards the end of the 2030s (chart). The federal budget deficit is currently running at around 6% of GDP, a level more commonly associated with recessions than economic expansions (chart). CBO projections suggest deficits will remain above 6% of GDP for years. Federal debt held by the public is already near 100% of GDP and, according to the CBO, is projected to exceed 150% by the mid-2050s (chart). Importantly, today's debt challenge is largely a government debt problem. Household and business debt relative to GDP remains well below its pre-GFC peak, while Treasury debt continues to trend higher (chart). The AI buildout could temporarily reverse that trend as businesses increase borrowing to fund AI-related investments. According to BIS data, the US is not the only country with a government debt problem, but it is among the most indebted major developed economies (chart). US government debt now exceeds 110% of GDP, above most peers and far above Germany. At roughly 250% of GDP, US economy-wide leverage remains below that of France and Canada, but exceeds Italy, the UK, and Germany (chart). China's debt burden has risen relentlessly over the past two decades. Total debt now stands at roughly 300% of GDP, exceeding US levels and reflecting years of credit-fueled growth, particularly in the property and infrastructure sectors. The US remains on an unsustainable fiscal path. Should investors be worried? Again, we will worry about the deficit and rising debt when the Bond Vigilantes start worrying about them. For now, we don't think we are there yet. Treasury yields remain in a range broadly consistent with a healthy economy, and we expect the 10-year yield to remain between 4.00% and 5.00%. Here are a couple of reasons that support this view: (1) US Treasury Secretary Scott Bessent has taken some actions recently to stop bond yields from rising. He has stated that the Treasury can do much more if necessary. If the 10-year Treasury yield rises to 5.00%, we expect he will announce that the Treasury intends to issue more Treasury bills and use some of the proceeds to buy back Treasury bonds. His predecessor, Janet Yellen, did that in 2023, and it worked. Remember, Bessent worked with Stanley Druckenmiller for Soros Fund Management in the early 1990s. Together, they shorted the British pound in September 1992, netting the hedge fund over $1 billion. They "broke the Bank of England." Bessent's recent actions are a signal to his friends in the hedge fund community that he will break them if they short his bonds! (2) Fed Chair Kevin Warsh has stated that the Fed is committed to restoring price stability. If inflation remains stubborn, the FOMC will probably raise the federal funds rate in September. That should restore the Fed's credibility as an inflation fighter and ease pressure on long-term yields. We told the Fed to do that in July, but they just won't listen.
Warsh World
Fed Chair Kevin Warsh isn’t one to give the markets a heads-up. Investors are trying to translate what he says into what he would like the Fed to do. To that end, Ed and Elias parse Warsh’s remarks last week at the Jackson Hole symposium. While Warsh’s assessment of economic conditions is hawkish, is it just hawkish squawk or indicative of his vote at September’s FOMC meeting? Whether he backs raising or maintaining the current federal funds rate may hinge on whether August inflation data suggest persistent weakness. But Warsh’s Jackson Hole comments did give the FOMC’s hawks some support and did shed some light on his policy approach.
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