Rickards: The Dollar’s Not Dying

Last week’s financial media was full of apocalyptic headlines: “$40 trillion in national debt!” “U.S. debt in a doom loop!” “The end of the dollar is near!”

Gold and bitcoin soared in lockstep with the dollar doom and gloom. If you took the headlines at face value, one would assume the dollar was already toast and U.S. Treasuries were worth no more than digital confetti.

The truth is that the dollar’s position as the leading reserve currency is not in jeopardy. Of course, foreign exchange reserves are not simply piles of currency. They are largely held in liquid financial assets, including U.S. Treasury securities denominated in dollars.

Dollar-denominated assets will dominate global reserves for decades to come.

The reason is simple. There are few sovereign bond markets with the size, liquidity and depth of the U.S. Treasury market. Other large government bond markets, including Japan and major European markets, do not offer the same combination of scale and liquidity. King dollar will remain king.

This does not mean interest rates won’t rise or inflation won’t increase. Both are likely. But neither means the end of the dollar. It just means the Treasury pays more to borrow and you pay more at the gas pump and grocery store.

So, there are problems in the dollar bond markets, but debasement-trade hysteria is not a useful way to understand them.

BESSENT GOES AFTER THE BOND MARKET

U.S. Treasury Secretary Scott Bessent has just announced a plan to address higher interest rates in U.S. Treasury securities markets and, by extension, mortgage and credit card markets. It has both long-term and short-term components.

One short-term component involves U.S. support for Japan’s efforts to prop up the yen, including joint currency intervention and potential greater use of the Federal Reserve’s FIMA Repo Facility. That facility allows Japan to borrow dollars against its U.S. Treasury holdings rather than selling those securities outright.

In turn, that could take pressure off U.S. interest rates. Japan is the world’s largest foreign holder of U.S. Treasuries, with about $1.12 trillion as of June.

Another short-term component is for the Treasury to purchase longer-dated Treasury securities, specifically those in the 10- to 30-year sectors. The Treasury recently announced that it will at least double the size of certain scheduled buyback operations from $2 billion to $4 billion, with the possibility of going higher.

Treasury has also relied heavily on short-term maturities such as one-month, three-month and six-month Treasury bills in its overall financing mix. These Treasury bills generally carry lower interest rates than longer-dated notes and bonds. Greater reliance on shorter maturities can lower U.S. interest expense, at least in the short run.

Treasury bills are also prized by dealers and hedge funds because they are highly liquid and are widely used as collateral in financial transactions. Supporting liquidity at the long end while maintaining a large supply of short-term Treasury securities makes sense. Why it is causing such hysteria in the media is a bit of a mystery.

BESSENT’S 3-3-3 GAMBIT

The longer-term component of the Bessent Plan is sometimes referred to as the Three Arrows.

The first arrow is to keep annual deficits at 3.0% or less of GDP. The second arrow is to achieve GDP growth of 3.0% or more. The third arrow is to increase U.S. energy production by the equivalent of 3 million barrels of oil per day.

That’s where the shorthand 3-3-3 comes from: a 3% deficit, 3% real GDP growth and 3 million additional barrels of oil equivalent per day.

Since oil output does not directly impact fiscal policy, we can leave that to one side in our analysis. The deficit and GDP growth targets, however, are critical.

The metric that really matters in terms of whether investors have confidence in U.S. Treasury securities is the U.S. debt-to-GDP ratio. It’s silly to hyperventilate about $40 trillion as the U.S. national debt unless you put that number in the context of the GDP available to finance and roll over the debt.

Right now, gross U.S. federal debt is roughly 123% of GDP. That’s the result of approximately $40 trillion of debt divided by roughly $32.5 trillion of annualized nominal GDP. That ratio is near the highest levels in U.S. history.

High debt-to-GDP ratios can be a drag on growth and leave governments with less room to respond to crises. A ratio of 60% is much more comfortable. A ratio of 30% is more comfortable still. The previous postwar high was reached around the end of World War II.

The annual deficit will not go down to zero. That’s a fantasy. The level of U.S. national debt will also not go down anytime soon. That’s another fantasy.

But that doesn’t matter.

What does matter is whether the debt-to-GDP ratio goes down.

The way to do that is to grow the economy faster than the debt. If you can do that, the ratio goes down even if the debt goes up. That’s Bessent’s plan. That’s what he meant when he said the U.S. could “grow its way out” of the debt problem. In theory, he was right.

For example, let’s say annual deficits are $2 trillion so that a year from now the national debt will be $42 trillion. That’s a 5.0% increase in the national debt.

But if GDP grows from $32.5 trillion to $34.5 trillion, that’s a 6.2% increase. The debt-to-GDP ratio drops from roughly 123% to 121.7%. That’s still high, but it’s lower than the year before.

That’s all the so-called bond market vigilantes need to see. As long as the debt-to-GDP ratio is coming down, bond investors have reason to retain confidence in U.S. Treasuries and the U.S. dollar.

The U.S. has done this before. The gross federal debt-to-GDP ratio reached roughly 119% in 1946 and was down to about 31% by 1980. That process took more than three decades and occurred under both parties using a combination of fiscal and monetary policy, strong nominal growth and inflation.

During that period, the national debt increased substantially. But GDP increased by more than 1,000%. And that was the key. If GDP grows faster than debt, the ratio comes down and America’s fiscal position improves.

HERE’S THE DIRTY LITTLE SECRET

So, that’s the plan. But there’s a dirty little secret that Bessent has not emphasized.

When the government computes debt-to-GDP ratios, it’s using nominal numbers, not numbers adjusted for inflation.

In the example above, GDP grew by about 6.2% while the national debt grew by 5.0%. That lowers the ratio, but it does not reveal how much of the GDP growth was real and how much was inflation.

The 6.2% nominal growth could have been 4.2% real growth plus 2.0% inflation. That’s fairly healthy. But it could have been 2.2% real growth plus 4.0% inflation.

At 4.0% annual inflation, the purchasing power of the dollar is cut roughly in half in about 18 years and cut in half again over the next 18 years. That kind of inflation can destroy your net worth and income if you’re not prepared.

So, how much inflation is included in the Bessent Plan? Secretary Bessent didn’t say.

Investors should assume the worst.

The U.S. has had difficulty sustaining real growth of more than about 2.0% per year on average since the global financial crisis. If we need roughly 6.0% nominal growth to outrun the growth in debt and if we can only produce 2.0% real growth per year, then the difference has to come from inflation.

That could mean 4.0% inflation.

That’s not a policy preference. It’s just fifth-grade math.

In describing how the U.S. lowered its debt-to-GDP ratio dramatically between the end of World War II and 1980, I conveniently omitted the fact that consumer prices rose about 50% between 1977 and 1981.

That’s one way the U.S. government took care of the debt problem.

I lived through that period. It was a fun time if you owned gold or real estate, if you used leverage and if you had a job that gave you a raise every few months.

It was not a fun time if you depended on fixed-income streams like annuities, insurance policies, pension plans or Social Security.

Which side of that trade are you on?