Black Swan Turns White On US Debt Default Probability

It's a reminder of how the US is likely to
stress-test the global economy as rarely before in 2024 and a moment of maximum anxiety for Asia. With China's property crisis undermining growth, Japanese growth flatlining and economies from South Korea to Indonesia to Thailand facing intensifying headwinds, the specter of turbulence from the West is slamming market confidence.

Taleb may be onto more than he knows. Former US Treasury Secretary
Robert Rubin has warned the current fiscal trajectory puts the US economy in a“terrible place.” Rubin, who helped lead the global response to the 1997-98 Asian crisis, recently told Bloomberg,“the risks are enormous and some of them are materializing already, like higher interest rates.”

Rubin earned his fiscal bona fides in the early 1990s as then-president Bill Clinton's economic czar. Back then, Rubin struck a deal with the Fed: debt reduction in exchange for rate cuts, an arrangement that led to a balanced US budget and surpluses, too.

Now Rubin worries that the 3-percentage-point surge in longer-term US yields is just the beginning. The fiscal outlook has darkened and inflation remains elevated. Rubin cautions that when markets are“out of sync with reality,” things can“correct savagely.”

Sadly, the political climate on Capitol Hill leaves little reason for hope lawmakers can head off catastrophe.

“Looking forward, we're having to deal with both spending and taxes,” Rubin notes. But“when you get realistic about it, I think you're going to have to largely” focus on the tax side to increase revenues.

As Rubin sees it,“there's a lot of talk but the talk is always divided politically between the Republicans who refuse to raise taxes and the Democrats who won't do entitlements.” His conclusion about Congress or the White House tackling the deficit is that“I wouldn't bet on it.”

As Moody's points out in a new report,“the greatest near-term danger to the dollar's position stems from the risk of confidence-sapping policy mistakes by the US authorities themselves, like a US default on its debt for example. Weakening institutions and a political pivot to protectionism threaten the dollar's global role.”

Moody's adds that“although we expect that politicians will eventually agree to raise or suspend the debt limit and avoid a default on government debt, greater polarization in the domestic political environment over the last decade has weakened both the predictability and effectiveness of US policymaking. Sanctions further inhibiting the free flow of the dollar in global trade and finance could encourage greater diversification.”

For now, the dollar benefits from a level of liquidity and low transaction costs with which peers can't compete. Moody's also points to a dearth of viable alternatives.
This may ensure the dollar's continued advantages in international trade and finance. Though down from 71% in 2000, 58% of central bank reserve levels around the globe are still in dollars.

Yet many worry the dollar is losing its reserve status faster than investors may realize, says economist Stephen Jen at Eurizon SLJ Capital. By Jen's calculations, the dollar's share of global reserves in 2023 fell at a rate 10 times the normal speed over the last 20 years.

In 2022 alone, Jen says,“the dollar suffered a stunning collapse” in its market share as a reserve currency,“presumably due to its muscular use of sanctions. Exceptional actions taken by the US and its allies against Russia have startled large reserve-holding countries,” most of which are emerging economies that constitute the so-called Global South.

In the past, Jen explains, the dollar was the“indisputable hegemonic reserve.” Still, he warns, its continued dominance“is not preordained” going forward.

“The prevailing view of 'nothing-to-see-here' on the US dollar as a reserve currency seems too innocuous and complacent,” Jen says.“What needs to be appreciated by investors is that, while the Global South is unable to totally avoid using the dollar, much of it has already become unwilling to do so.”

Louis Gave, economist at Gavekal Dragonomics, notes that“the dollar remains the world's
reserve
currency, but for how long? After all, some 20% of the global oil trade is being settled in non-dollar currencies, debt in most emerging markets is outperforming treasuries in a tightening cycle and gold is breaking out.”

Cryptocurrencies, too. Andrew Peel, head of digital asset markets at Morgan Stanley, says Bitcoin's“remarkable” adoption worldwide may accelerate the erosion in the dollar's standing. He notes that 100 million people worldwide hold the cryptocurrency while companies like Tesla and nations like El Salvador are going digital.

Of course, not everyone thinks the dollar's days are numbered. Valentin Marinov, strategist at Credit Agricole, notes that the euro's share of international SWIFT transactions has“collapsed” while those in Japanese yen and British pound have“moderated.”

The“importance of the dollar as the currency of choice for international payments and transactions is another reason for global official and private investors to buy the currency,” Marinov says.“In turn, this should slow down further any push towards de-dollarization.”

The yuan is indeed making major inroads versus the dollar, both in global finance and trade. But some wonder if China's policy missteps over the last few years might slow the yuan's momentum toward reserve-currency status.

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Fallout from President Xi Jinping's crackdowns on tech and finance, on top of draconian Covid lockdowns, continues to weigh on economic growth. A $7 trillion stock rout since 2021 is further damaging investor confidence.

Now, Xi's determination to boost the yuan's value may bring unintended consequences, notes economist Rory Green at TS Lombard. Letting the exchange rate rise“could act to constrain monetary policy,” Green says.

In general, Green adds, the People's Bank of China might be wary of easing monetary policy to avoid downward pressure on the exchange rate.

“Needless to say,” Green notes,“an artificially strong currency attached to a weak economy is not a good combination.”

Even so, the“white swan” troubles facing the US are about to intensify.

They include renewed contagion fears. Concerns about a reckoning for the US commercial property market are going global. In America, a slower-than-expected return to offices following the pandemic has occupancy rates skyrocketing.

Exposure to the sector saw Japan's Aozora Bank record its first loss in 15 years. Moody's cut New York Community Bancorp (NYCB) to junk amid real estate-related problems. Germany's Deutsche Pfandbriefbank flagged its exposure to the“greatest real estate crisis since the financial crisis.”

Silicon Valley Bank's troubles could still be the tip of the iceberg for US banks. Image: Screengrab / Twitter / TechCrunch

On Tuesday, US Treasury Secretary
Janet Yellen
felt the need to step to the microphone to claim all's well in the financial system.

This week, NYCB shares closed at the lowest level since 1997 as about $4.5 billion of its market value evaporated. Moody's says the institution faces“multi-faceted” market risks and governance challenges.

“There are reasons to think that NYCB is not the only struggling US bank, as others face a squeeze on both profits and asset quality,” write analysts at Gavekal.“But the problems seem especially acute among small banks, which have some 30% of their assets in the troubled commercial real estate sector compared to 6% at large banks.”

All this coming a year after the spectacular demise of California's Silicon Valley Bank is putting Asian markets directly in harm's way.
And in ways that no one could argue markets didn't see coming.

Even the man who popularized the idea of unforeseeable risks now says“black” is“white” where financial risks in 2024 are concerned.

Follow William Pesek on X at @WilliamPesek

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