About the author: Desmond Lachman is a Senior Fellow at the American Enterprise Institute. He was Associate Director in the Policy Development and Review Division of the International Monetary Fund and Chief Strategist for Emerging Markets at Salomon Smith Barney.
There is an apocryphal story about the investigation into the sinking of the Titanic. When the Titanic’s captain was asked why he didn’t dodge to avoid the iceberg, he replied, “What iceberg?”
Judging from Federal Reserve Chairman Jerome Powell’s silence on the warning signs of crises in the world’s three largest government bond markets, one has to wonder whether he could soon be accused of something similar when it comes to a future financial market crisis. When asked why the Fed hasn’t backed off its aggressive monetary policy stance of raising interest rates and quantitative tightening in the face of the looming sovereign debt crises, he might reply, “Which debt crises?”
The truth is that, for a variety of reasons, we could have debt crises as early as this summer in the world’s three largest government bond markets: the United States, Japan and Italy. Should any of these crises occur, they could shake up the currently illiquid world financial markets. They could do so in the same way that the recent collapse of the UK gilt market, following former Prime Minister Liz Truss’ ill-advised budget, rocked UK financial markets.
By far the most worrying potential debt crisis is that in the United States. This is not only because the US has by far the largest market for government bonds. This is also because the US debt market serves as a risk-free rate against which other interest rates around the world are priced. A rise in the US 10-year Treasury rate would impact the global economy.
The reason for fears of a US sovereign debt crisis this summer is the ongoing showdown over raising the debt ceiling. In a letter to House Speaker Kevin McCarthy, Treasury Secretary Janet Yellen pointed out that the US government hit its debt ceiling on Thursday. She also pointed out that the Treasury Department is now taking “extraordinary measures” which should allow the government to avoid a debt default until at least early June.
The huge gap between the majority of the Republican House of Representatives and the initial positions of the Biden administration on this issue makes a protracted battle over the debt ceiling all the more likely. McCarthy, who is committed to the Republican Party’s Freedom Caucus, reiterates that he will not agree to a debt ceiling hike without committing to large cuts in public spending, including Social Security and Medicare spending. For his part, Biden believes the debt ceiling should be raised unconditionally as Congress has already approved the underlying spending.
As we should have learned from the 2011 US debt ceiling battle, financial markets can become very unsettled when debt negotiations stall. That was the case in 2011, although in the end a debt default could be avoided. Needless to say, should the US actually default, all hell would break loose in world financial markets as the creditworthiness of the world’s largest sovereign debtor would be called into question.
The reason to fear a Japanese sovereign debt crisis is the recent rise in that country’s core inflation rate to 4%. A new Bank of Japan governor is expected to take office in April. A crisis could come soon after. Inflation could force the BOJ to abandon its current policy of yield curve control. This, in turn, could lead to a sharp rise in long-dated Japanese government bond yields. As in the UK recently, an unexpected rise in government bond yields could sideline large Japanese financial institutions.
As if that weren’t enough to keep central bankers up at night, there is also a real risk of another round of Europe’s sovereign debt crisis unfolding later this year. It would focus on Italy, which has the third largest government bond market in the world.
So far, the European Central Bank has kept the heavily indebted Italian sovereign afloat by buying all of that country’s net government bond issuance as part of its quantitative easing policy. However, the ECB has announced that it will begin a €15 billion ($16 billion) a month quantitative tightening policy starting in March. This must raise the question of who will fund the Italian government’s gross borrowing needs of more than $250 billion this year, and at what rate?
Even ahead of a sovereign debt crisis, rapidly declining US inflation and a slowdown in the US economy would have justified a pause in the Fed’s rate hikes and a slowdown in the pace of quantitative tightening. Now that there are good reasons to fear an imminent sovereign debt crisis in at least one of the major debtor countries, there seems to be all the more reason for the Fed to pause if it is to avoid monetary overkill.
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