a “sudden stop” with american characteristics

I just reviewed a couple of threads about ka-poom from long ago. The model was based on the idea of a “sudden stop”, which is a crisis that occurs [historically] in a developing country when capital inflows cease.





To my knowledge there has never been a sudden stop in a developed country, let alone the country which supplies the global reserve currency, as does the U.S.

Foreign cb’s stopped accumulating treasuries in q3 or q4 of 2014 iirc, and [I think it was] earlier this year the cost of hedging currency exposure made nominally positive, globally high, u.s. treasury rates go negative in real terms for private foreign buyers unwilling to assume currency risk. Although some foreign buyers may be willing to assume that risk, large institutions such as pension funds, insurance companies and wealth funds are not likely to do so. [too much career risk for the portfolio managers]

Thus, foreign capital inflows into the treasury market have ceased. Remember this is the condition that is required to produce a sudden stop.

The U.S. has responded over the past several years by e.g. requiring money market funds to buy more treasuries, increasing required bank reserves, and so on. And of course in dec 2017 the tax cut and jobs act explicitly encouraged the repatriation of foreign earnings that u.s. companies had been holding abroad. [these funds were overwhelmingly used for stock buybacks, goosing management stock options while pushing up equity prices. i’m sure a good chunk of money eventuallyfound its way into bonds.]

Those wells have now run dry. In the future we might expect to see requirements that pension plans and even private ira’s have a certain percentage of assets in treasuries. EJ mentioned capital controls – the u.s. has made it progressively harder for ordinary individuals to establish foreign bank accounts. The onerous reporting requirements have made most foreign banks loath to create accounts for americans. And even if they do, then those accounts must be reported by the account holder annually to the irs. [the really wealthy of course have ways around this, via shell companies established in various “friendly” countries.] even in the absence of formal currency controls, it is de facto harder and harder for u.s. investors to get money out of the country.

[and btw, if you look at what’s been happening in the U.S. financial markets there has been a flood of money into fixed income ETF’s and funds- mom and pop are helping finance the deficit. Of course mom and pop also heavily bought into the dot-com’s near the peak, and into housing in 2004-07 and we know how that worked out.]

A few months ago, however, even those flows into treasuries ceased to be adequate. The U.S. is running deficits over $1trillion [according the gao “During fiscal year 2019 (ended sept 2019), total federal debt increased by about $1.2 trillion.”].This during what is supposedly a time of economic growth and record low unemployment. But nonetheless a few months ago cash became tight, and banks became reluctant to lend to one another. Repo rates spiked as high as 10%.

The fed to the rescue: it is now supplying over $60Billion/month via the repo market in an intervention that, they want to make absolutely, crystal clear, is NOT qe. Nonetheless the fed has in the last few months completely reversed the liquidity drain it so painfully implemented in the prior year. The fed’s balance sheet is up $280 Billion in the last 11 weeks because of not-QE.

So a sudden stop is what happens when foreign inflows of capital cease. Check.

But of course it’s playing out differently in the global hegemon than it has in emerging markets.

First, its effects are not quite as sudden. They were sudden in the repo market, but that’s a fairly obscure corner of the financial markets. The fed jumped on it, and to all appearances the problem is contained. [but remember how subprime was “contained”?]

If you recall the original ka-poom illustration, inflation skyrockets immediately after the sudden stop. Officially measured inflation is up a bit in the u.s., but hardly skyrocketing. But it IS up a bit.

No one cares about deficits anymore, notice? Not worth a mention. Iirc the u.s. will borrow a net of about $1.3 over the current fiscal year. Assuming there is no recession, of course.

If there is a recession expect the deficit to quickly rise above $2Trillion/year. It’s going there anyway,[e.g. the gov’t will not reneg on social security or medicare] it’s just a question of how fast.

The fed is now bruiting about a proposal that it allow future inflation to “make up” for the inflation shortfalls of recent years. i.e. it will push for inflation ABOVE 2% for some time. Another fed governor has talked about controlling the yield curve, so that long-dated treasuries won’t rise above 2.5-3%, i.e. the fed will guarantee that all treasuries of all durations offer only negative real yields.

This set of circumstances HAS occurred before in the u.s. It was during the great depression and wwii. The fed pinned rates, and often was the major buyer of treasury bill offerings. That is to say it monetized federal debt.

The results? Treasury bonds were money-good. Holders got their money as promised, it just wasn’t worth nearly as much. Inflation was significant. Equities, as claims on real assets and entities, outperformed inflation.

Inflation is coming, but not as quickly and dramatically as in the sudden stop graph. Instead it will come like a Hemingway character described going bankrupt: gradually, then suddenly.