Forex Blog: Currency Trading News & Analysis.

August 18th 2010

US National Debt and the US Dollar

Pessimists love to point to the surging US National Debt as an indication that the Dollar will one day collapse. And yet, not only has the US Dollar avoided collapse , but is actually holding steady in spite of record-setting budget deficits. That being the case, one has to wonder: As far as the forex markets are concerned, does this debt even matter?

In attempting to answer this question, it makes sense to start by asking whether investors in general care about perennial budget deficits and an-ever increasing national debt. A rudimentary examination suggests that they don’t. Treasury Bond Yields have been falling slowly over the last 30 years. In fact, this fall has accelerated over the last two years, to the point that US Treasury Yields touched an all-time low in 2009, and are currently hovering close to those levels. As of today, the 10-year Treasury rate is an astonishingly tiny 2.7%.

US 10-Year Treasury Rate 1960-2010

Of course, everyone knows that this most recent drop in Treasury rates is not connected to the creditworthiness of the federal government, but rather an increase in risk aversion engendered first by the credit crisis and second by the EU Sovereign debt crisis. The Federal Reserve Bank and other Central Banks should also receive some of the credit, thanks to their multi-billion Dollar purchases. Still, the implication is that US Treasury securities are the safest investment in the world and that a default by the US government is seen as an unlikely outcome. Thus, investors are willing to accept meager returns for lending to the US.

While demand has remained strong in spite of record issuance of new debt, the structure of that demand has undergone a profound shift. Less than 20 years ago, the overwhelming majority (~85%) of Treasury Bonds were held by domestic investors. In 2010, that proportion had fallen to about half. The largest individual holders of US debt are no longer US institutional investors, but Central Banks, namely those of China, Japan, and Oil Exporting countries. Due to the continued expansion of its quantitative easing program, The Federal Reserve Bank has also become a major buyer of US Treasuries.

US Federal Debt Held by Foreign Investors
It’s tempting to dismiss these purchases as unrepresentative of overall market sentiment, since Central Banks have objectives different from private investors. What matters, though, is that ultimately, such Central Banks would not continue lending to the US government is they thought there was a real possibility of not being repaid. To illustrate this point, consider that the People’s Bank of China (PBOC) actually jettisoned nearly $100 Billion in Treasury debt over the last year as part of a restructuring of its foreign exchange reserves. However, it still has $840 Billion in its possession.  In contrast, the Bank of Japan increased its reserves over the same time period by a similar amount.

As for the forex markets’ assessment of the US debt situation, this is difficult to isolate. There appears to be a relatively stable correlation between the Dollar (vis-a-vis the Euro) and long-term US interest rates, as exemplified by the Euro rally and simultaneous fall in US interest rates. One explanation for the fall in the Dollar, then, could be that falling interest rates made it an attractive funding currency for a carry trade strategy. On the other hand, there would also appear to be an inherent contradiction here, since a rising Euro is an indication of increased risk tolerance and, thus, should be accompanied by a sell-off in US Treasury bonds and rising yields. That in reality, rates fell as the Euro rose confounds our efforts means any correlation is probably dubious.

US Dollar and US 10-Year Rate

You don’t need me to tell you that in the short-term, the skyrocketing US debt is of zero concern to the forex markets. There is simply too many other issues on the radar screens of investors for them to make a meaningful attempt at assessing the likelihood of default. Such concerns might become more pronounced in the long-term, but it seems kind of silly to incorporate them into present forecasts. Even if the Eurozone debt crisis were to resolve itself and the global economy managed to avoid a double-dip recession, some other crisis or development – especially one more concrete and immediate than the distant possibility of a US debt default – would materialize. In short, it will be many years before the US debt problem becomes serious enough as to warrant serious consideration by the forex markets.

SocialTwist Tell-a-Friend
Posted by Adam Kritzer | in Central Banks, News, US Dollar | 3 Comments »

Sponsored Offers

FREE Daily Email Updates

Enter your email address:

Delivered by FeedBurner

3 Comments of “US National Debt and the US Dollar”

  1. Jason Says:

    Great post Adam.
    The US debt will be a major problem, but not anytime soon.
    IMO The Euro should return to parity with the USD. It will probably take years and years, but with all the debt crisis in Europe, there’s no sense to see the EUR above the USD.

  2. Adam Says:

    Although the US appears to have a weak economy and many think the dollar will crash one day, I beleive that the US is a leading indicator of the world economy and that as the US recovers, other countries will go through similar situations with their currencies. We have already seen the economic crises almost take down the euro with situations like there was recently in Greece.

  3. Debt Ratio Says:

    Pessimists love to show the surge of U.S. national debt to show that the dollar will collapse one day. And yet, not just the U.S. dollar to avoid the collapse, but in reality, taking steady despite record budget deficits. This is something that must be asked: What are the forex markets are concerned, this debt even matter? In trying to answer this question, it makes sense to start asking investors generally do not care perennial budget deficit and growing national debt. Elementary analysis shows that they are not. Treasury bond yields have fallen slowly over the past 30 years. In fact, this decline has accelerated over the past two years, to the point that U.S. Treasury yields hit a record low in 2009, and currently manages close to these levels. To date, the 10-year Treasury is a surprisingly small 2.7%.

Have Questions? Want to Share Your Review?

Be heard. Please share your reviews today!

Neighboring Posts

© 2004 - 2024 Forex Blog.org. Currency charts © their sources. While we aim to analyze and try to forceast the forex markets, none of what we publish should be taken as personalized investment advice. Forex exchange rates depend on many factors like monetary policy, currency inflation, and geo-political risks that may not be forseen. Forex trading & investing involves a significant risk of loss.