Time to Pay the Piper Redux
A year on we are reminded of the saying, "No matter how bad things are, they can always get worse".
When I wrote part one of this Pay the Piper missive we were just at the front end of this rather tawdry story, We are now reaching the middle chapters, you know, the part where our hero (the US economy) is beset by all sorts of troubles but instead of succumbing to mind-numbing terror he vows to fight on and triumph in the end. Typical Marvel comic book superhero plot. Or maybe Shakespeare if you are the more cultured type.
After the stock market fell down an elevator shaft in 2022 and all seemed dark, the Artificial Intelligence savior made his appearance. Cloudy visions of massive productivity increases dawned and even the temporary setback of the Silicon Valley Bank crisis could not dampen the enthusiasm. We were saved! Or maybe not. The bank failures were, at root, caused by the incessant short-term interest rate tightening from the Federal Reserve pushing against the assumed safety of holding long-dated US Treasuries in what were euphemistically called “Hold to Maturity” assets. In reality, necessity would cause them to be priced at their present greatly reduced value when a run on the bank threatened liquidity. Maybe ZIRP should have been called Zap! The situation still exists for many banks but that is not part of this story, there will be a spinoff for that.
In its typical myopic groupthink Wall Street has been fixated on the Fed setting short term interest rates for almost two years now. Commentators and analysts breathlessly await the smallest verb variation to divine what the august body might do at the next conclave. They have been distressed by the yield curve inversion without seeing its obvious cause. As the Fed increases short term rates, short term rates go up. What a surprise. So focused have they been on hoped-for rate cuts that they paid no attention to the possibility that the rate curve would uninvert by long rates rising above the already high short rates.
Long rates are not set at a meeting by decree from on high, they are a result of a first economic principle, supply and demand. The profligate spending by the government is necessitating an unprecedented amount of supply. Wall Street pundits seem to have an aversion to taking government fiscal policy into account. And who can blame them, businesses that have rubbed up against politics have often been spanked and spanked hard. They send their K Street minions down to the capitol to beg for incentives or fight taxes but now they are being confronted by the fact that fiscal policy matters. The folly of pushing for government spending to boost their favored business interests is becoming clearer by the day. Who knew that cajoling the government to throw borrowed dollars at chip plants, EV subsidies, wind farms, soar panels and such would make THEIR borrowing costs spike? Last year Federal expenditures were 26% of total American GDP. What the government spends and borrows has a giant effect on the economy writ large.
The Federal Reserve, who ran up their balance sheet to nine trillion dollars in a fit of zero interest post GFC and Covid stimulus understands that their glass is overflowing and can’t continue to hold that much juice and are backing away from quantitative easing. Remember, they are a bank too and the lessons of “Hold to Maturity” and “Mark to Market” apply to them as well. When they began QE voices in the wilderness advised against it, predicting that we would end up where we are now. If something can’t go on forever, it won’t. Getting in is easy, it’s getting back out that’s hard. So they have had to hunker down and stop buying T-Bills while their inflated holdings run off month by month. The first rule of being in a hole is to stop digging. After all, their hoard is much too large to sell off without decimating the new issuance market and just like the banks, they are waaaay
under water. They can’t afford to “Mark to Market”.
Synchronously the great China decoupling is being pushed in Washington and Beijing for very different reasons. Washington fears our abject dependency on China for consumer goods, medicine, electronics and cheap non-union labor. China wants to be the dominant economic power in the world and understands that the dollar and world dependence on US debt as a safe foreign exchange holding stand in the way. They also saw the sanctions on Russia after the Ukraine invasion and want to insulate themselves from such treatment when they seize Taiwan. So they have mostly stopped buying US Treasuries and are even selling some of their pile. Japan has their own bond worries. Foreign buyers across the globe are backing away.
Another major purchaser of Treasuries is the mega-banking system. But for all the reasons we covered earlier in this missive they are afraid of long durations that must be held to maturity. Many banks in the regional banking system and even some of the majors are facing whispers about the amount of duration risk on their books. Liquidity is king right now.
There are a limited number of options to climb this mountain of debt we have created. They already tried inflating their way out of it but the American public howled so loudly that the frightened central bankers and politicians ran for the hills. Taxes could be raised dramatically but that would have the same effect only with the donor class joining the chorus. They could cut discretionary spending by huge amounts, cut the Federal work force by half, remove the income cap on Social Security contributions and ration Medicare and Medicaid. Raise your hand if you see that happening. Anyone? Anyone? The idea of growing our way out of debt is laughable given that the deficit is currently 8% of GDP. In a few years even those choices will be obsolete and default will be forced on the previously richest country in the world.
The buyer of last resort is the American public. Expect bankers, advisers and portfolio managers to begin pushing for direct ownership of Treasuries in your portfolio. They want someone to fund the government between now and the inevitable default, they just don’t want it to be them. Someone has to take the loss, it might as well be you.