How the New U.S. Fiscal Stimulus Package May Impact the Dollar

President Barack Obama recently unveiled a $3.35 trillion budget of which $816 billion over a 10-year period is meant to provide stimulus to the ailing U.S. economy. He has some company - in significantly diminishing magnitude of outlay - as China unveiled a $530 billion package back in November, the EU approved a €200 billion stimulus, Germany specifically posted a €50 billion ($63 billion) package, the UK at £25.6 billion ($38.8 billion) and France at €26 billion ($33 billion). The world will soon be flush of capital but two key questions from a USD perspective are: a) is it really enough, and b) will it really have an impact on the direction of the USD? My conclusion is that: a) no, and b) yes. So let's delve into the details.

The key for the USD is what will happen to interest rates since the world will have to fund this U.S. deficit, projected at 1.75 trillion dollars including TARP funding in 2010. At this pace, the U.S. Treasury will have to raise debt at unprecedented levels. The math goes something like this.

The $1.75 trillion equates to roughly $145.83 billion per month that the U.S. Treasury will have to fund. Based on last year's average TIC (Treasury International Capital) flows for the U.S., the Treasury ended up with about $52 billion per month. Since the Treasury needed about $37 billion per month to cover its $455 billion deficit, TIC flows more than covered it. (Of course, TIC is not the only capital source for U.S. securities purchases although it is the material one otherwise the U.S. Secretary of State would not be "hawking" U.S. Treasuries on her Asia trip?) Now, presume the same average level of TIC flow occurs in 2009, which is an unlikely assumption given that sovereign debt funds, foreign government, international money management firms all must scale back due to responding to dire local economic recessions and or poor investment yields abroad. This means reaching that average TIC flow is likely to be quite short of the mark. Be that as it may, we are looking at a monthly shortfall of about $94 billion, or an annual shortfall of $1.125 trillion. Not good. So where does the money come from?

The top seven countries of TIC net outflow comprise 70 percent of the world's net TIC. These countries/entities are, in capital purchase order, China, Japan, Caribbean banking centers, Oil Exporters, UK, Brazil and Russia. The last two have shown a YOY decline of 2.25 percent and 1.1 percent, respectively, in U.S. Treasury securities purchases from 2007 to 2008. The top seven in the list average, interestingly enough, about $39 billion in U.S. Treasury securities purchased per month, which is close to what the Treasury needed to fund its 2008 deficit of $455 billion. So, given these conditions and the fact that the U.S. needs to fund a shortfall of $94 billion per month in fiscal year 2009/2010, what will it do? Well, since everyone talks about how China is funding the US, et al., let's examine this supposition.

First, China averaged about $21 billion in Treasury purchases per month in 2008, making it clearly the largest U.S. asset purchaser. But do they have any more headroom? First, China Premier Jiabao's surprising announcement today of no further stimulus needed other than what was announced last November, seems enough to the PRC to ensure the country can maintain at least six-percent growth (which results in their officially stated unemployment rate of 4 percent). Regardless, with budget defecits looking to run at 3% of GDP (normally 1%), we ask, where does their money come from? Up until mid-2008 their surplus cash has been a function of excess trade balances creating close to $2 trillion in currency reserves over the past 10 years. This year for the first time, they are running government budget deficits and have eaten about $50 billion of the currency reserves. In November 2008, their budget deficit stood at a modest $22 billion of which their treasury must manage the shortfall. Let's say they continue to run deficits of that magnitude per month for one year until their stimulus truly kicks in. Well, that amount basically offsets their ongoing U.S. Treasury purchases, which in the worst case scenario for the U.S. means that our $94 billion monthly funding shortfall shoots up to $114 billion with nobody to replace that money.

So, back to my question above, who pays the U.S. bill? The U.S. taxpayer? Yes, to a certain extent as tax increases are expected to raise about $318 billion over 10 years from those who make over $200k per year. But clearly, that's nowhere near enough. Then there is of course the 44 percent of the American employed that technically do not pay taxes. Taxing them might help, but doesn't win you a congressional seat let alone a second presidential term.

If the taxpayer can't bailout the U.S., who is left? You know the answer: the bank of last resort, The Federal Reserve Bank . And that is the rub. If the Fed is fundamentally asked to foot the bill for the deficit, global investors will have no confidence in the U.S. because then the emperor will truly have no clothes as the Fed merely prints more USD bills than it's worth. The basic result is spiraling inflation and a severe decline in the USD, if not crash. To tiptoe a little down this dark path, we see that M3 (full measure of inflation) has spiked to over 15 percent YOY growth, all in the last four months. The difference between rates on 10-year notes and comparable TIPS (Treasury Inflation Protection Securities), which reflects the outlook among traders for consumer prices, touched 1.15 percentage points yesterday, the widest since October 21 and showing no signs of abating. In the long term, you're going to see Treasury yields rise as we deal with the mother of all supply challenges. Add to it the fact that gold has risen 12 percent over the past two months just speaks to the "tip of the iceberg" on this line of thought. If the Fed buys, you will see double digit interest rates in the U.S. by 2011 as a worst case scenario.

So, how to avoid the "end of the world?" Certainly, I don't have the answer as there are many brilliant people worldwide trying very hard to figure this out. It ultimately depends on some simple assumptions all working in the next couple of years, such as the 3.2 percent U.S. GDP growth forecast by the CBO for 2010, the collective global fiscal stimulus measures and the aspired coordination of central banks and treasuries (reminiscent of hand-holding drunken sailors trying to stay on the plus side of a wobbly financial boat). I believe it to be more simple than that. I say the solution may come from innovators like our customer base of venture capitalists and these brave entrepreneurial early and mid-stage companies and their people doing what it takes to forge new industries, create new forms of value and do it with "chutzpah." And this attitude is truly global. No government on the planet can possibly suppress the growing roar of global small business!