Busch: If You Think It's Bad Now

In the midst of mega-global deflationary pressures, we're setting the ground work for a future return of inflation, lower bond prices, and US dollar weakness. Let's begin our tale of future woe by focusing on the basics of supply and demand.

We know the future supply of US Treasury securities is going to increase in a Zeppelin-like way due to the Obama administration's spending plans. The $787 billion stimulus plan, $350 billion for new TARP, the new budget of $3.6 trillion, and the approval last night of a $410 billion spending bill necessitates the US Treasury to increase borrowing. The estimated deficit is currently $1.75 trillion that could easily reach $2 trillion if corporate/personal tax revenues decline.

Fortunately at this time, there has been tremendous demand for all US Treasury securities due to the credit crisis. The theme has been return Of capital not return On capital ever since last September. There has also been a global shortage of US dollars needed to meet debt service as the corporations, banks, and hedge funds all have been forced to raise capital and delever. One of the off-shoots that central banks developed to increase the supply of US dollars has been the increased use of swap lines with the US Federal Reserve.

Another development, the creation of quantitative easing programs around the globe. On Thursday, the Swiss National Bank is expected to begin buying foreign bonds as a way to increase money supply and weaken the currency. The Bank of England is going to officially start their quantitative easing program today by offering to buy up to 2 billion pounds of government bonds. Lastly, the US Federal Reserve will meet next week and is expected to debate whether to begin buying US Treasury securities with the same goal in mind.

Over the last two days, we've seen potential financial paradigm changes to the Chinese structure towards US dollar reserves. The first news was the abrupt arrival of deflation in China with consumer prices dropping 1.6% in February and the producer price index falling 4.5%. Today, China announced a staggering 25.7% drop in exports and a tiny trade surplus of $4.8 billion versus expectations of $39.1 billion. This means that there is a massive drop in the Chinese supply of US dollars via trade.

Put another way, the drop in trade means less US dollars that the Chinese receive and less they need to recycle back to the US with purchases of US Treasuries. This same scenario is occurring in Japan. Therefore, the two largest holders/accumulators of US dollar reserves and US Treasury securities are both likely to decrease both.

This is why members of the ruling Democratic government in the US are pushing back on $410 spending bill and will likely fight the new Obama budget. This is why investors like Bill Gross, Warren Buffett, and Marc Faber have been getting concerned over inflation starting from 2010. This is why the US 10 year note has seen it's yield increase 50% since the beginning of the year even in the midst of the "Great Recession" from 2% to 3%. This is why the I think the currency markets could shift their focus from a private sector capital raising/deleveraging benefiting the US dollar to a public sector capital demand that will hurt the US dollar.

Ultimately, higher US government debt supply with higher US dollar supply in the midst of weakening foreign investor demand will create inflation and higher than normal bond yields.

The higher interest rates will cascade through the US economy to cut off the potential growth rates which may eventually return in 2010.

________________________

v align="left">

Andrew Busch
Andrew Busch

Andrew B. Busch is Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him here. </</p>