On November 8, 2022, I posted the piece called “Are we Still in Kansas?” As almost a year has gone by, I thought a look-back might be worthwhile.
In that piece, I wrote, among other things:
” … some math to consider. Under the recent QE program, the Fed was buying about $1T in US Treasury securities per year, and about $500B mortgage-backed securities. The 2022 fiscal deficit was $1.4T. From 2020-2022 the fiscal deficits have totaled about $7.5T and the Fed has net funded over $4T of that, monetizing $4T of debt. So, the Fed has been the marginal buyer of the majority of the increase in US Treasury supply since before the pandemic. To be sure, we have seen a run-up in Treasury yields in 2022 as QE stopped and QT began, all while the deficit ran to $1.4T in 2022. But going forward, the Fed process is reversing (remember, year-to-date the rundown of the Treasury General Account has completely offset QT so far). While the fiscal deficit for 2023 is forecast to lower to “only” $900B (optimistic), the Fed is SELLING over $1T per year of US Treasury securities under the Quantitative Tightening regime instead of buying that $900B as it would have under QE.
So, there is a marginal increase in supply of US Treasuries in fiscal 2023 of over $2T ($900B deficit + > $1T QT) versus 2022, which has to be absorbed somehow. We have lost the largest buyer of US Treasury securities for the last several years in the form of the Fed. We have also lost the second largest buyer of US Treasuries in the form of foreign central banks. Looking further out, by 2032 the CBO forecast is for an AVERAGE of $1.6T in federal deficits per year, adding another $14-16T or so of debt to be absorbed. So, who is going to buy that increased supply of US Treasuries next year and over the next decade, and at what interest rate, if not the Fed? (A lot more to discuss here but that’s for another day).”
Fast forward to October 2023, the $900B deficit forecast from that time period was indeed optimistic, having nearly doubled to $1.7T. That means the market has to absorb that $1.7T PLUS the $1T of QT from the Fed. A total of $2.7T of Treasuries represents 10% of GDP roughly. The question remains: who is going to buy those Treasuries, and what is the implication for the level of interest rates needed to clear them?
As I write, the US 10-Year treasury flirted with 5% despite two regional wars, meaning the flight to quality isn’t behaving consistently with historical behavior. We may be seeing a bid today (10/23/23) as hedge fund manager Bill Ackman unwinds his funds’ bearish bets on USTs. There is more chatter that the Fed is done raising rates. But, that doesn’t change the overall fact that interest rates on USTs have zoomed past 15-year highs over the last 4-6 weeks!
As it relates to who is going to buy them, we know (or greatly suspect) its not the Fed, we know its not the Bank of Japan, we know its not the PBOC, and we know that banks are less interested in UST due to current portfolio losses and due to proposed increased capital requirements to hold treasuries. These are the four largest buyers of UST going back a while. Is Bill Ackman going to buy UST or just unwind his shorts!
Does the loss of historical largest buyers of UST help explain the recent run-up in UST yields despite two regional wars? It does to me. What does it mean for the future direction of interest rates? Are there other potential flashpoints in the world that could cause the typical flight to quality? Sure: oil-rich Azerbaijan’s recent conflict with Armenia-leaning Nagorno-Karabach could expand to Armenia itself. Serbia and Kosovo are potentially at it again. Not to mention Taiwan. However, those seem more like “trades” in UST to me than true investment, though if that happens this trade could run some amount of time, to be sure – there is still a lot of money swimming around as discussed below. To me, true investment will be driven more by the disparity between the $2.7T (or more) annual supply of UST and the world economy’s demand for that amount.
Consider the following:
- $7.6T, or 31% of UST debt, must be rolled over next year. We need current investors in those to re-up or the amount needed for new buyers will increase over the $2.7T mentioned above.
- The CBO assumed an average 3.8% interest rate in its July 2023 forecast, and 10-year yields are 1% higher than that. Short-term rates exceed 5%, so as that $7.6T of debt gets rolled over, the average interest rate on the outstanding UST debt will greatly exceed the July 2023 CBO forecast.
- In the current fiscal year, interest expense in the Federal budget will exceed $800B, up more than double from 2021’s $350B number.
- On current trends, interest expense will exceed Defense spending in 2025 and Medicare spending in 2026.
- The US represents 4% of the global population, but represents 40% of global government budget deficits, and 60% of global governments’ current account deficits. To keep the “show on the road”, to quote Louis Gave, the US must attract “50-60% of the marginal increase in [global] savings year in and year out.”
- In 2022, the US froze Russia’s foreign exchange assets for foreign policy reasons, sending a message to sovereign holders of UST that they might want to consider other investments going forward. Is that conducive to getting 50-60% of the marginal increase in global savings?
What this all means to me is that the fundamental forces affecting UST yields are going to keep upward pressure on yields so that we can line up enough buyers to invest in UST instead of investing in something else. Of course, the Fed could decide to re-start their historical asset-buying to protect the federal budget deficit, bringing back the largest buyer of UST over the last 5 years or so in the process. As I wrote in last year’s post: Will we return to Kansas at some point? Maybe, perhaps even probably. At some point, it would not be surprising that the Fed will have to lower interest rates and resort to again buying assets.”
If (or when) the Fed does this, it will increase the money supply, which should be expected to have the impact on prices that we’ve seen over the last few years, i.e. inflation should be expected to re-appear instead of prices continuing moderate. To date, the Fed has reduced its balance sheet liabilities to about $7.9T from a peak of about $8.9T. Money supply as expressed by M2 came down from $21.9T in April 2023 to about $20.8T in September 2023.
On top of those events helping inflation to subside, the Treasury General Account has take another $800B out of the economy by increasing its balance from $40B in May (pre-debt deal) to $840B in October 2023. That represents eight months of Fed QT in only 4 months. So, these figures help explain why core inflation has come down.
But, interest expense in the Federal budget is beginning to explode and neither party is demonstrating the onions to do what is needed to restrain spending. Taxes can only go up so much before adversely affecting GDP. Right now, Fed liabilities to GDP ratio is still 29%, down from a peak of 35-36%, when historically it has been below 10% and was never above 16% prior to 2008. So, there is still a lot of money in the system. That is why the “last mile” of the fight on inflation is difficult this time. And, this is even before the Fed may revert back to QE, or even before our politicians get religion and address the deficit (which will hurt GDP in the process, keeping ratios elevated, etc.).
We’re in a tough spot. What to do? As I wrote in November 2022: “… 1) increase cash to the extent you can, 2) if you don’t have a working capital line of credit, try to get one, 3) use a higher interest rate for capital planning purposes than you have been, and 4) modify the design of your project to fit within the new cost reality.”
These remain important management considerations as conditions have worsened than outlined when I wrote that. We’ll get through this. Focus on why you started your school(s) in the first place, and know that your efforts are worth it and will positively change the trajectory of your students’ lives for years to come. And as always, let me know if you need to talk something through.