Bond Yields Up, Dollar Down…What Gives?

The US dollar dropped to its lowest level in three years Friday.

Extending losses on Thursday, the dollar index against a basket of six currencies dropped to 88.253. This marks its lowest level since December 2014.

A Reuters report noted that “Traders’ confidence in the dollar has also been eroded by mounting worries over the United States’ twin budget and current account deficits.” Interestingly, just last month Peter Schiff said these twin deficits may ultimately doom the stock market.

If we have a return of the twin deficits as a problem in 2018 – I’m talking about the budget deficit and the trade deficit – twin deficits. You know the last time that was a big problem? It was in 1987. What happened in 1987? We got a stock market crash. I know that was just over 20 years ago, but what was happening then reminds me a lot of what’s happening now. We had the stock market roaring. Everybody was confident. But people were overlooking these gigantic problems until they couldn’t overlook them anymore and then it ended in a spectacular crash.”

The US trade deficit widened more than expected in December to its highest level since 2008. The trade deficit increased 5.3% to $53.1 billion in the last month of 2017. That came on the heels of a 3.2% increase in November.

Meanwhile, the US federal government continues to pile up debt. The budget passed last week added some $300 billion in deficit spending and raised the mythical debt ceiling. According to the Committee for a Responsible Federal Budget, $300 billion in additional spending will ensure the annual budget deficit will exceed $1 trillion in 2019.

This helps explains a strange phenomenon we’re seeing in the markets. The dollar is getting weaker even as bond yields increase. Generally, the dollar strengthens as Treasury yields rise. But as Reuters reported, Treasury yields have hit four-year highs, with inflation coming in stronger than expected in January. This bolsters expectations that the Fed will continue to increase interest rates this year. The dollar should love this but it’s still falling.

What gives?

ING head of currency strategy Chris Turner told Reuters he thinks the weakening dollar could be explained by the fact that yields are rising on the back of worries over the budget deficit rather than inflation.

This year’s rise in Treasury yields has been driven more by the term premium – that’s a risk premium investors require for holding long-term debt. International investors are requiring a concession in the dollar to hold US assets because of the fiscal risk.”

So, why would budget deficits push yields up? It’s simple supply and demand. The Treasury Department is going to have to sell trillions of dollars in bonds over the next few years to pay for all of this spending. This comes at a time when the three biggest buyers of US debt aren’t in a buying mood. Yields have to rise to entice people to buy all of these Treasuries.

Rising interest rates create another problem nobody is really talking about. According to analysis by SRSrocco, every increase of 0.1% in the average interest rate, the US government has to pay an additional $20.5 billion in interest expense. Since tax revenue is basically fixed (and decreasing due to the GOP tax plan), every dollar that goes toward making interest payments is a dollar that can’t be used to cover current spending. This means that the government will have to borrow even more money (at a higher interest rate) to cover the ballooning interest payments.

Talk about a vicious cycle.

We’re already seeing the impact of rising rates. According to SRSrocco, interest expense paid for the first three months of fiscal 2018 increased to $147 billion compared to $139 billion in the same period last year.

The US government paid $126.5 billion to service their debt Oct-Dec 2015.  We must remember, the US government fiscal period starts in October.  So, in just two years, the interest expense the US government paid for Oct-Dec increased more than $20 billion.  Now, what is interesting is that the average interest rate in December 2015 was 2.33%, but in December 2017 it was only 2.31%.  Thus, it was actually lower, even though the interest expense increased by $20 billion. The reason for the $20 billion increase in the interest expense during Oct-Dec 2017 versus Oct-Dec 2015 was due to a more than $2 trillion increase in US debt over that two-year period.  So, the US government will have a serious problem as interest rates really start to rise… and that doesn’t even include the continued increase in total US debt.”

No wonder Austrailian central bank president Governor Philip Lowe called the rising US budget deficit “very problematic.”

Last fall, Mint Capital strategist Bill Blain said he believed, “The great crash of 2018 is going to start in the deeper, darker depths of the credit market.” With surging government debt piled on top of a heaping helping of household debt, it’s looking like Blain may have been right.

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