A looming US fiscal crisis could hit the Gulf hard

Sipa USA via Reuters Connect

The GCC currency pegs to the dollar ensure that regional central banks shadow US interest rates. 

During times of dollar strength and rising US interest rates, the GCC asset markets are vulnerable to monetary contraction. 

Since the currencies cannot devalue against the dollar due to the logic of the peg, the burden of adjustment falls disproportionately on domestic share and property markets, which explains the sheer amplitude of asset market swings.

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It is no coincidence that the high implied volatilities of the GCC equities markets make them among the highest beta equity asset classes in the world – that is, they tend to outperform or underperform wildly. 

Unfortunately, the alarming fiscal breakdown metrics in the US suggests that the primary trend in US interest rates will be higher even after 11 successive rate hikes have failed to bring inflation down to the central bank’s two percent dual mandate target. 

The yield on the 10-year US Treasury note – the GCC’s de facto benchmark cost of long-term capital – is now just below 5 percent and interest rate volatility is on a secular uptrend. Tight money Fed policy is converging with a polarised Congress to confront an embryonic fiscal crisis that casts a malign shadow on the future of the global economy.

The traditional inflation risk premium on long term US interest rates is set to move higher because the US fiscal deficit is now a colossal $1.7 trillion – more than 6 percent of the American GDP at a time when the economy is at almost full employment. 

Geopolitics alone guarantees that Uncle Sam’s budget deficit will spike next year. President Biden asked Congress for $105 billion in supplementary funds to finance US military aid to Ukraine, Israel, border security and the naval arms race in the Pacific against Chinese threats to Taiwan.

It is alarming that the net Federal debt-to-GDP ratio in the US is 106 percent in peace time with no recession, a level last seen at the end of World War II.

The return of the bond vigilantes from the early Clinton era in the 1990s is thus inevitable and reinforces my conviction that the primary trend in dollar bond yields is significantly higher, despite a recent dip below 5 percent on relatively benign October PMI and payrolls data. 

The looming fiscal crisis is all the more alarming because the political elite in the Republican and Democratic parties have not mobilised to address it, as the Reagan White House and Democratic speaker Tip O’Neill did with their epic budget compromise deals in 1986.

If current trends continue, it is almost certain that the US budget deficit will reach $2 trillion within the next two years. This could be catastrophic for the global economy at a time when Europe is mired in stagflation, China faces an epic property/municipal debt crisis and dozens of emerging markets will be forced to go cap in hand to the IMF to avert sovereign default.

The American political process makes it impossible for any major political party to cut entitlement spending, social security and Medicare to its 78-million strong baby boomer retiree cohort.

A US recession in 2024 will only accelerate the onset of a fiscal crisis that the Biden White House, the Powell Fed and Congress can do very little to now avert.

The cost of borrowing has also moved sharply higher since the Fed tightening cycle began in March 2022. This means that the rising cost of debt servicing will be another contributor to Uncle Sam’s looming fiscal crisis. 

We could see a vicious cycle witnessed in inflation- and debt-plagued emerging markets. Rising bond yields lead to higher debt servicing costs, which in turn raise real interest rates, worsen the debt ratio and trigger the classic macro vicious cycle.

The mathematics of the US budget deficit in 2023 are surreal. Congressional spending is 25 percent of the $25 trillion US GDP, although US tax revenues are barely 19 percent of economic output.

The US political process in election year makes any credible discussion of entitlement reform or tax rises unthinkable by President Biden and any of his Republican challengers.

The failure of the political process to address the budget deficit means that the bond vigilantes of Wall Street will now enforce fiscal discipline via the brutal mechanism of much higher dollar interest rates. 

The GCC economies should thus brace themselves for a period of monetary contraction and a liquidity squeeze even as oil prices fall in 2024.

Matein Khalid is the chief investment officer in the private office of Abdulla Saeed Al Naboodah and the CEO designate of a venture capital firm. He is also adjunct professor of real estate investing and banking at the American University of Sharjah