This article first appeared in Forum, The Edge Malaysia Weekly on October 9, 2023 - October 15, 2023

Something is going on in the House of the Dollar, the mightiest currency in the world. You would have thought that with everyone fleeing to the US dollar, attracted by high interest rates, the Numero Uno would be laughing all the way to the bank, quietly taking the money in.

Instead, American politicians started squabbling about a possible government shutdown with President Joe Biden joining the union workers in strikes against the automotive industry. Who is really in charge of managing the world’s premier currency?

On Sept 30, the US government narrowly averted shutdown after Congress passed a last-minute bill to allow for 45 days of additional funding for an agreeable budget to be negotiated. The severe way in which the US conducts its politics is at odds with the “risk-free” perception the country enjoys in financial markets. US Treasury bonds are widely adopted as benchmark rates against which all financial product riskiness is measured. No other country has such an exorbitant privilege. Yet, political brinkmanship is a feature of the American system, not a bug.

There have been 10 budgetary shutdowns in the last 40 years — all without lasting consequences. The longest one was on President Barack Obama’s watch, which lasted more than a month from Dec 21, 2018 to Jan 25, 2019. This stems from political infighting over a stricter legal interpretation of deficit spending adopted from 1980 onwards, which the BBC pointed out had the effect of: “no budget, no spending”. Fiscal hawks like Republicans want to rein in government spending, whereas fiscal doves, mostly Democrats, are willing to continue spending and increasing the budget deficit, cumulatively growing the largest sovereign debt in history.

Markets largely treated the threats of a US government shutdown with nonchalance. Few believed that the country would threaten its greatest financial weapon, the dollar. Instead, traders focused on inflation risk (the real rates of return), because higher nominal rates compensated for the perceived higher credit risks. After the US Federal Reserve hinted that interest rates could stay higher for longer, the yield on 10-year US Treasury bonds rose to 4.57% by the end of last week, gaining 48 basis points in September alone. Both domestic and foreign investors welcomed the higher returns, especially since the inversion of the yield curve is a harbinger of recession, which is generally bullish for bonds.

The budgetary showdown brings the sheer size of the US fiscal deficit into focus. In the first 11 months of fiscal year 2023, from Oct 1, 2022 to Aug 31, 2023, the size of the deficit swelled to 7% of US gross domestic product (GDP), excluding unique charges, which was nearly double the 3.8% shortfall recorded in a similar period last year. This was largely attributed to lower fiscal revenues received after the economic bounce back in 2021 and 2022, both being pandemic years. On the other hand, expenditure was sticky at 19.5% of GDP. Naturally, Congressional Republicans concluded that deeper cuts in spending are needed and threatened to withhold support for a new federal budget to get their way, setting the scene for last week’s high drama.

There is no consensus regarding the US fiscal health prognosis. The Congressional Budget Office (CBO), the agency responsible for helping Congress independently assess fiscal trends, declined to predict a crisis except to note that growing US public debt would heighten the risks of one occurring. In the 2023 Long-Term Budget Outlook, CBO projected that the fiscal deficit ratio would initially decline but eventually rise to 10% of GDP by 2053. The long-term average ratio is in the region of 2%-3% of GDP. The rise in the deficit ratio would push the outstanding debt-to-GDP from 98% in 2023 to 181%, because the government would be forced to pay higher funding costs, literally borrowing just to pay interest costs. According to Maya MacGuineas, president of the think tank Committee for a Responsible Federal Budget (CRFB), this trajectory is “unsustainable”, because balancing the budget becomes impossible. To do so would require nearly 

US$15 trillion of cumulative savings in the next 10 years, meaning that government spending would either be cut by nearly half the size of the US economy or taxes would have to rise accordingly.

The brutal realities of the US’ economic health have global implications for the risk-free status of the US dollar.

Rising US bond yields will lead to a repricing of all other financial risk assets in the physical or derivative markets, affecting sovereign bonds and foreign stocks. The Fed’s aggressive monetary tightening raised the overall cost of funding for the US government with net interest payments growing from 2.0% to 2.4% of GDP in the first 11 months of FY2023. According to the CRFB, more than half of the US$26 trillion outstanding public debt will mature in the next three years creating the need for refinancing. This incurs significant rollover risk because nearly 80% of the current debt was priced when interest rates were significantly under 4% per annum. Should interest rates remain higher for longer, the fiscal burden imposed by higher interest payments is baked into a structurally higher level.

Louise Sheiner of the Brookings Institute suggests a neutral debt outcome is possible if the higher interest rates are offset by gains in productivity growth (she suggests artificial intelligence as a potential contributor). This appears in line with CBO estimates that by 2033, real interest rates on public debt (nominal interest rates less forecast inflation) would be 1.4%, trailing expected real GDP growth of 1.7%. On the other hand, if such productivity cannot be realised, slower growth plus higher real interest rates can only worsen the US fiscal situation. In this scenario, the recent rate rise may have marked a turning point in US creditworthiness for the worse.

The Fed is the bellwether in this conundrum. Despite pausing rate hikes in September, Fed chair Jerome Powell told markets: “Broadly, stronger activity means we have to do more with rates”, signalling a surprise hike may be in store to take the upper li­mit of benchmark interest rates from 5.50% to 5.75%. The hawkish tone led to the big moves in US Treasury yields last month. At present, most Fed officials expect interest rates to fall sometime next year (“dot plot”), with a mean centred around 5% before edging down to 4% or less in 2025. Crucially, this will depend on how the US economy trends. While the Fed appears to be aiming for a “soft landing” from inflation, some economists believe the undercurrents of a recession have formed. Signals of economic weaknesses included the downward trend in payroll growth and hours worked, decreased corporate appetite for capital expenditure and bank loan officers expressing caution over lending to consumers.

The Congressional fiasco over the federal budget shutdown showed that the debate over US fiscal sustainability is deadly serious. Politicians may toy with partisan politics but Treasury Secretary and former Fed chair Janet Yellen has warned that hardball tactics “cannot be normalised as the way we do business in Washington”.

If the world’s largest economy mishandles its fiscal position and thus threatens the mighty US dollar’s dominant position as the world’s reserve currency, we are all passengers for the wild ride ahead.

Tan Sri Andrew Sheng writes on global issues that affect investors. Tan Yi Kai is a Malaysian multi-asset trader based in Hong Kong.

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