(Bloomberg View) -- The U.S. Treasury has been stealthily weakening the dollar. It isn’t clear if it is doing so consciously, but since a weaker dollar suits Treasury leadership, there probably isn’t too much concern. The key is that the Treasury is flooding the market with short-term debt that neither domestic nor foreign investors are very interested in buying. The Federal Reserve is capping the yield on the debt with its promises to raise rates gradually and to keep rates below long-term levels for some time. Taken together, we have a surge of short-term issuance at very negative real rates.
The skew in issuance is striking. Since August 2017, Treasury bills, which mature in one year or less, have represented 63 percent of the increase in bills, notes and bonds, as the chart below shows. As a share of the total stock, bills have gone from 14 percent to 16 percent during the past six months.
So how do you attract buyers when supply is booming and the yield is held down by your friendly central bank? The discount that foreign buyers require to induce them to buy comes through a weaker exchange rate. If Treasury is issuing so much, and you are getting paid relatively little in terms of rates, you want potential upside via foreign-exchange gains. That translates into weaker dollar spot prices. Nudging the dollar down by more than the fundamentals would justify increases the odds of eventual appreciation, so the added supply at low yields winds up finding buyers.
I call it stealth intervention, even though the Treasury isn’t engaged in buying or selling either dollars, or foreign currencies. However, it is creating conditions where the rational market outcome is that the dollar must be weaker to create demand for all the low-yield debt that’s being issued.
This added supply of short-term debt may also explain the widening of money-market spreads. Short-term private money-market rates have been rising sharply versus fed funds and Treasuries. The level of fed funds largely pins down yields on riskless Treasury obligations. If investor demand for short-term debt is limited and the riskless yields are held down by the Fed, private-sector issuers have to pay up in terms of yields to sell their debt.
If Treasury were disproportionately issuing debt with longer maturities and higher yields, investors would still need a discount to buy. However, that discount would be reflected in lower prices (higher yields), and a weaker exchange rate. When yields are not able to move much because they are anchored by the Fed, the discount required at the short-tend relies wholly on a weaker exchange rate. The foreign-exchange impact may be particularly pronounced in countries like the U.S., with fiscal and trade deficits, and that require foreign capital one way or another.
This may also be the reason for the breakdown between interest rates and foreign-exchange rates. The standard relationship of a positive correlation between interest rates and exchange rates has an implicit assumption that supply of debt isn’t the reason that exchange rates are moving. Most of the time, the interest move primarily reflects expectations of central bank behavior, not underlying supply or demand conditions. When the central bank raises rates and we see an increase in both domestic and foreign demand for debt, assuming a stable supply, leading to currency appreciation. In the current situation, investors are looking at a big incremental supply of debt driven by both Treasury supply and the Fed shrinking its balance sheet, against the backdrop of the Fed’s expected gradual rate hikes. In a country with a current account deficit, you need foreign savings to fund debt. The question is how much currency weakness it takes to generate the right risk-return profile to generate the required saving.
Mea culpa: I had argued earlier that real interest rates looked as if they were driving dollar weakness, with U.S. expected real yields lagging versus the euro zone. The data have not supported this explanation. There is a link between the two explanations, in that the Fed promise to move gradually means that investors in U.S. fixed income are unsatisfied that they are adequately compensated for shifting fundamentals. Here I am emphasizing the fundamental supply-demand balance, rather than inflation risk.
From a Treasury viewpoint, the motivation for issuing short-term debt is clear. U.S. one- and three-month bills yield about 100 basis points less than seven- and 10-year notes, and about 125 bps less than 30 year bonds. You can debate the long-term wisdom of shortening maturities, but the near-term saving on debt servicing is clear. Treasury may also have an eye on the Fed’s shrinking balance sheet increasing supply at longer terms.
From a foreign exchange viewpoint, it is as if the Treasury said, “We are going to weaken the U.S. dollar until it is attractive enough to induce foreigners to buy our short-term debt.” There is a point at which foreigners might balk at buying the debt, but that point remains relatively distant. Were that to happen, the dollar would collapse and both short- and long-term risk premiums would rise sharply. As many developing economies have found, exchange-rate weakening that starts off as being beneficial to competitiveness can morph into something much worse. For now, I suspect the Treasury thinks its debt-management policy is paying a double dividend of low yields and a weaker dollar.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Steven Englander is the head of research and strategy at Rafiki Capital. He was previously the head of G10 currency strategy at Citigroup and the chief U.S. currency strategist at Barclays.
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