by C Hamilton
America (and the world at large) are in the midst of an entirely predictable demographically driven crisis, between an economic/financial system requiring infinite growth and a very finite human/physical world. This mismatch will only become more acute for decades to come. As the growth of demand is decelerating, central banks are using interest rate policy cuts to encourage higher consumption via greater leverage/debt. Federal debt is soaring absent the economic (and tax revenue) growth to accompany this deluge of debt. I will show that the primary purchasing sources of that debt have turned to net sellers…and that into this breach, the Fed has thrust itself as the buyer (counterfeiter) of last resort. The result is likely to be a Minsky Melt-Up…and then the fall that typically follows.
First, by year end 2020 (estimated below), federal debt will almost surely cross $28 trillion while GDP will collapse in Q2 with likely recovery through Q3/Q4. The outcome will be a debt to GDP ratio likely around 140%…smashing the WWII previous high water mark. Noteworthy also in the chart below are the new standards of ZIRP and reliance on the Federal Reserve balance sheet (QE) to maintain zero percent interest rates.
Since 2008, public (marketable) federal debt has nearly quadrupled, up by $14.7 trillion. Social Security and like Intragovernmental trust fund holdings have risen $1.8 trillion. The Federal Reserve balance sheet has increased by 8x’s, up by $6.3 trillion. In fact, most simply, it is the Federal Reserve using it’s balance sheet as the substitute for the demographically decelerating IG purchasing. As the IG holdings will only continue to decline due to the unfunded liabilities (and with it the primary source of Treasury buying for decades turns to a decade of Treasury selling), the Fed’s balance sheet will rise inversely to avoid an interest rate Armageddon.
To underscore the Fed’s role as buyer of last resort, below are the four classes of Treasury buyers/holders. I split the change in holdings by group, per period:
- 2009 through ’14…the QE years (everybody buys…especially Fed, Foreigners)
- 2015 through ’19…the QT years (IG and especially domestic sources do the buying, Fed sells, foreigners pass)
- January through May, 2020…the p(l)andemic 5 months (IG sells, foreigners pass, Fed goes wild w/ a domestic assist (unfortunately, Treasury Bulletin for 2020 won’t be available for a while to detail who exactly those domestic buyers of 0.6% yielding 10 year and 1.2% yielding 30 year bonds were))
While the Federal Reserve has decreed the Federal Funds rate to be zero and undertaken QE to distort rates, Congress has understood this zero interest rate policy to mean “free” money since the interest rates are so low. The Federal Reserve’s actions have destroyed Congress’ primary role of compromise, striking a balance between spending and taxation. For those that wonder why “fiscal conservatism” died, it was the Federal Reserve that killed it.
Ok, let’s focus on the Fed’s balance sheet. The Fed is presently slamming on the brakes on it’s QE Corona-virus operation, from a peak purchase of $585 billion weekly to “just” $68 billion this week. And the Fed is communicating they will continue to slow their purchasing. Chart below shows the Fed balance sheet (red line) and weekly change (black columns) since 2008. I assume the Fed will continue tapering their purchases through year end 2020, ending the year with a balance sheet of something like $8.3 trillion (adding about $4.5 trillion since QT ended in September 2019, or a 220% increase of it’s balance sheet in 15 months time).
The Fed truly distorted the interest rates of Treasuries with it’s massive purchases in such a short period. Given the duration and laddering of bonds, only a relatively small percentage is available at any certain time so the size and suddenness of the Fed purchases overwhelmed the Treasury market.
During QE Corona-Virus, the Fed has thus far purchased $587 billion in T-Bills…in fact even this week, the Fed did most of its ongoing buying here, adding an additional $33 billion in T-Bills (effectively further steeping the curve between short and long duration rates).
The nearly $600 billion in freshly conjured demand collapsed the short end of the curve (3 month T-Bill shown below) to zero. But despite the enormous Fed purchasing, the natural rate is likely significantly higher than 0.2%…and without ongoing Fed subjugation, rates will continue to rise.
Notes (1yr-5yr Duration)
From the completion of QT to present, the Fed has purchased $750 billion in shorter duration Notes…but the buying has ceased, as the holdings have stalled for nearly a month now.
Again, the Fed has distorted the free market setting of rates with it’s conjured money but rates are turning upward and as the supply of new and rollover Notes continues, the absence of demand typically results in rising rates.
Notes (5yr to 10yr Duration)
Below, longer duration Fed held Notes. The $470 billion rise in Fed holdings since the end of QT is hard to miss…but equally important is the decelerating purchasing of more debt and the Fed signaling it will only continue at low levels of purchasing.
Since the overwhelming flood of Fed purchasing has subsided, the all important 10 year Treasury rate is suddenly rising…like an inflatable held down underwater. The Fed has temporarily distorted the free market rates of Notes with it’s conjured money. However, rates are turning upward and as the supply of new and rollover Notes continues, the absence of demand typically results in rising rates…as we are now seeing. The impact of a fast rising 10 year (the foundation of the 30 year mortgage rate) would rapidly push mortgage rates on primary and commercial real estate to significantly higher levels…and crush a housing led “v-shaped” recovery meme?!?
The Fed purchased $312 billion of Treasury Bonds since QT was abandoned. Given the much smaller quantity outstanding of long bonds, this represented more than 10% of all marketable long bonds in just a few months time, increasing the Fed’s total long bond holdings to nearly 35% of marketable.
The Fed’s action of plunging the 30 year rate to nearly 1% was a deformation of incredible proportion…but just as incredible would be the rate counter reaction upward absent the Fed’s ongoing bid.
Excess Reserves vs. Monetization
Is the Fed about to back off and let the “free-market” determine Treasury interest rates? Not likely, the Fed no longer (if ever) believes in free market price discovery. So, best to check the Fed’s balance sheet split between the portion held in large banks as excess reserves and the portion moving directly into the economy/financial system (monetization). When the Fed began QE, Ben Bernanke then stated the Fed would not monetize the debt and that the Fed conjured dollars would be held essentially inert as excess reserves…and then subsequently be removed via quantitative tightening. This was a bald faced lie then and is even more laughable now. During the initial stages of QE, about 2/3rds of the Federal Reserve newly created dollars were held as excess reserves (+$2.7 T) while (+$1.2 T) moved into the financial system.
And the impact of monetization on asset prices (showing Wilshire 5000, representing all publicly held US equities).
Focusing on monetization since QE ended in late 2014 through the present…a strong correlation should be noted between the rising quantity of monetization (post QE) and asset valuations.
During the last cycle (post QE) the Fed raised IOER’s alongside the FFR%, essentially paying banks not to loan money, paying them for taking no risk. This time, the Fed is offering essentially no payment on the excess reserves, encouraging banks to employ those reserves…and that is exactly what I anticipate we will see. The chart below details the IOER’s (interest paid on excess reserves, held at the largest of banks) versus the excess reserves and monetization. The Fed continuing QE alongside declining excess reserves, will push the quantity of monetization into orbit.
If the excess reserves decline and the correlations hold (both as expected)…all those freshly conjured dollars will be in frantic search for a leveraged home via loans and/or asset purchase…and look out as assets explode higher on a wave of “legal” counterfeit Fed cash. Perhaps there will be some sort of quid pro quo, by which the largest banks maintain the Treasury bid while simultaneously leveraging up…or perhaps the Fed will double down it’s Treasury purchasing, otherwise rates will soar alongside equities?
And just so we are clear, this surge in asset prices will benefit a small minority of Americans and actively harm the vast majority via costs of living surging versus significant unemployment and flat wages. Wonder how that will go over as 2020 is likely to only get a whole lot more “interesting”!?!