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Wednesday January 12, 2005 - 16:11:26 GMT

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Crucial role for US Treasury

Crucial role for US Treasury

The US Treasury will face tough challenges in 2005 with the need to manage budget and dollar policies. It will be vital for the political arm of the administration and the Treasury to co-ordinate policy closely, especially if US bond yields start to increase. The administration will push for greater Asian currency flexibility, but will also need to be very careful not to trigger a bond-market or dollar collapse. Any evidence of serious policy divisions between US policymakers would risk heavy bond and currency losses.

Treasury concerns?

The US Treasury, together with the administration in general, has a vital role to play during 2005. The US is running a record current account deficit while the budget deficit is also at a peace-time record high in cyclically-adjusted terms.

During the fourth quarter of 2004, the Treasury failed to make any significant defence of the dollar. To some extent, this reflects the partial vacuum between the November presidential election and Bush’s inauguration for a second term on January 20th.
In the first 10 days of 2005, there has been some tentative evidence of a policy shift, illustrated by frequent media interviews by Treasury Secretary Snow. Snow stated that the US was prepared to take action to curb the budget deficits and the Treasury Secretary also refused to rule out currency intervention. It is dangerous to over-interpret the remarks, especially as he later repeated the mantra of exchange rates being market led. Nevertheless, there may be greater US concerns that a policy of dollar neglect will be counter-productive. This will certainly put the February G7 meeting in focus while the late January budget presentation will also be watched closely.

Debt fears will increase

The US Treasury market conditions have been benign over the past 12 months. 10-year yields have remained low, generally below 4.4%,despite firm growth and higher short-term interest rates. The funding of carry trades through low short-term interest rates, coupled with heavy overseas demand for US Treasuries due to intervention proceeds, guaranteed a favourable supply and demand balance. Conditions are unlikely to be as favourable during 2005. The US Federal Reserve is committed to further short-term rate increase and there will be a risk that foreign demand for US Treasures will decline. This will make it more difficult for the US to fund the budget deficit. Rising interest rates will also make it more expensive for the US Treasury to fund interest payments on Treasury debt. The US debt is currently standing at US$7.6trn and debt payments for fiscal 2003/04 amounted to US$322bn. A sustained rise in bond yields would result in additional interest payments, compounding the debt and budget concerns.

The flurry of activity over the past week suggests that the Treasury is becoming more concerned over the situation, especially with the Fed warning clearly that further interest rates will be required.

Overseas funding a concern
Overseas central banks have been a major source of bond buying over the past 12 months as intervention proceeds were re-invested in US Treasuries. Any shortfall in overseas funding via Asian currency appreciation or a loss of confidence in US assets could seriously destabilise the markets. The administration will, therefore, also need to be very careful over its dollar policy and work closely with the Treasury and Commerce departments. Apparent indifference to the dollar would risk an exodus of funds and a sharp increase in bond yields.

Personnel in focus

There will be concerns that a second term for US Treasury Secretary Snow is only a stop-gap measure with Bush looking to replace him early in his second term. The markets will demand a credible replacement and cohesive policies. There will also be some concerns that the administration will pursue a more nationalistic policy in its second term which could increase trade tensions.

Fed Chairman Greenspan will also retire at the end of this year after being in charge at the Fed for 18 years. This Fed shift and market uncertainty will make consistent Treasury policy more important than usual.


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