tunnel REUTERS/Arnd Wiegmann

  • The US budget and current account deficits raise the risk of a debt crisis, Deutsche Bank said in a recent note.
  • The Treasury Department is expected next week to announce a second increase this year in the size of its note and bond auctions to fund government spending.
  • Foreign demand for Treasurys has recently weakened, Deutsche Bank observed, although the US still enjoys the advantage of owning the world's reserve currency of choice.

The US budget and current account deficits raise the risk of a debt crisis.

America's fiscal situation right now as measured by its debt-to-GDP ratio is not very dissimilar from the average of other G20 countries over the past five years, said Deutsche Bank's Quinn Brody and Torsten Sløk in a note. But that could be about to change.

"Recent tax cuts to corporates and households have, however, forced us to negatively reevaluate the fiscal outlook," the Deutsche Bank strategists said. "The combination of substantially lower revenues along with steadily rising entitlement outlays will result in rising deficits over the next decade."

Additionally, they observed that the US is the only major economy on track to grow its debt over the next five years. Next week Wednesday, the Treasury is expected to announce that it will raise the sizes of note and bond auctions for the second time this year to fund the government's spending needs.

Deutsche Bank

As the custodian of the world's reserve currency of choice, there's no imminent threat of a US debt crisis, Brody and Sløk note. But there's reason to at the very least sound an alarm.

The Congressional Budget Office, for example, warned that the US faces a higher risk of a fiscal crisis if the current trends and policies continue. America's spending habits, the CBO said, could also raise the risk that investors would "become unwilling to finance the government's borrowing unless they were compensated with very high interest rates."

"Investors should continue to monitor the tail risk of a US debt crisis by watching the outcome of US Treasury auctions for signs of weaker demand. So far, Treasury auctions are seeing sufficient demand but demand from abroad has been trending lower in recent years and the bid-to-cover ratio has been declining, including for T-bills and 2-year and 10-year Treasury auctions. Conditions are not abnormal by pre-crisis standards, but they are trending in a less-supportive direction."

Foreign demand for Treasury bills has recently softened as the dollar has weakened, hedging costs have risen for international investors, and valuations in US stocks have stretched, Deutsche Bank said.

Deutsche Bank

That's why the place to watch for early signs of a fiscal crisis is the US Treasury's weekly auctions of bills, for signs that external demand to fund US debt is waning. This takes on more importance this year, as Treasury raises its issuance to help fund the government's spending.

The Federal Reserve is fading as a source of support for Treasurys, since it's shrinking the balance sheet it built after the crisis. Although the unwind is in autopilot mode and short-term interest rates are the policy instrument of choice, the Fed has indicated that it's willing to tweak the program if the economy's trajectory warrants it.

"We cannot say exactly what level of debt (85% of GDP? 100%? 125%?) will prove to be the tipping point, but we do believe that the latest fiscal developments have increased the odds of a crisis," Brody and Sløk said. "Investors should continue to monitor Treasury auction developments and will remain alert to any indications of softening demand," they concluded.