THE THREE INTERESTS SHAPING THE ECONOMY
Self Interest, Government Interest & The Inverted Yield Curve Interest
The debt ceiling resolved as self-interest trumped a default and resulting catastrophic scenario as we surmised in our last blog. Despite the close to inevitable outcome, the topic commanded weeks of media time on a drama that was akin to playing Russian Roulette with no ammunition in the chamber. A default scenario was not ever in the cards. The notion of crashing the US and Global economy and writing off the US as a global economic influencer in one polarized political decision was beyond even the current political actors and theatre in DC.
So, while the short-cut to financial Armageddon was by-passed, the current trajectory of American monetary policy is paving the way to like unsavory financial outcomes. The current will to get to a balanced budget by both parties is as distant as the milky way. The big picture, however, is rarely on anyone’s minds in a world where political capital relies on the printer staying on, memories span days and modern monetary theory postulates that governments can print as much money as they want without economic consequences. That has not worked out well for empire builders throughout history. Self-interest can typically be always relied upon to trump philosophy and facts.
Now that we have covered self-interest and self-preservation in the economic equation, let us examine the current financial environment in the US and the challenges it poses for the captains of the US financial system. To do that we need to examine the bogeymen at the door of the Federal Reserve and US Treasury, some may say (not the Fed of course), mostly of their own making.
- Underwater US Treasury Bonds
- An Inverted Yield Curve
- Deposit exodus from banks to MMF’s (Money Market Funds)
- Interest on short-term and long-term debt
As we have discussed in prior blog articles, the close to zero-interest environment in the 2020/2021 timeframe combined with excess liquidity, money printing and leverage led - unsurprisingly - to the first culprit: Inflation. As if these factors were not enough, inflation got a further boost from constrained supply chain issues and corporations not missing an opportunity to raise their prices. The Federal Reserve – surprisingly ☹ surprised by this - was left no choice but to apply economic chemotherapy and raise interest rates. It did so at one of the fastest paces in its history.
This brings us to the next chapter in the unfolding saga: Underwater US Treasury Bonds. Banks were accumulating substantial UST's [bonds] during the low to zero-interest rate period which included excess liquidity and rising deposits. Despite the rise in rates being loudly broadcasted in advance, banks did not hedge the risk, assuming they could carry the obligations to maturity without risk. As a result they have been holding substantial unrealized losses on their balance sheets. This along with depositors being able to find higher yields elsewhere with the US Treasury or Money Market Funds left bank models looking more vulnerable and less profitable, especially the not-too-big-to-fail banks. As we saw with Silicon Valley Bank, the deposit exodus necessitated the sale of bonds at large losses which they followed up with an ill-timed fund raise and insolvency rumors swirling on social media which in turn saw a bank with over 270 billion in assets disappear from the landscape in less time than one could say “Jiminy Cricket”! More banks have followed suit and there may well be more to come depending on the Fed's actions.
As if the above were not sufficient challenge for the banks, the inversion of the Yield Curve has added yet another wrinkle. Banks make money when the yield curve slopes positively, borrowing cheaply via customer deposits, central bank windows or the short end of the curve, and lending longer term at higher rates - a classic 'carry trade' or "buy low, sell higher" foundation model for operating a business. When the yield curve inverts banks must pay a higher short-term interest rate on deposits and are unable to lend those deposits out longer term at a higher rate. The result: lending is curtailed which is in line with the Federal Reserve mandate to bring down inflation, e.g. slow down the economy.
A yield inversion curve broadcasts that investors expect higher short-term rates, but are growing nervous about the Fed's ability to control inflation without significantly hurting growth. The 2/10-year yield curve has inverted six to 24 months before each recession since 1955. Anu Gaggar, global investment strategist for Commonwealth Financial Network, found that the 2/10 spread has inverted 28 times since 1900. In 22 of these instances, a recession followed. Again, one can say that this narrative is supportive of the Fed’s mandate to bring inflation down.
The above can be further compounded by companies - who borrowed in a low-rate environment - having to re-finance some of that debt at higher rates in a more unfavorable economy, negatively impacting their businesses. We have discussed the commercial real estate industry in other blog posts as one example of an industry that has loans falling into this category over the next 1-3 years and widely held by the not-too-big-to-fail banks.
Where to Now?
The Fed has communicated it remains steadfastly committed to bringing down inflation to its 2% per annum mandate. The question is how far does the Fed need to go to meet this mandate? Raising interest further will exacerbate the banking crisis and along with QT (quantitative tightening) contract the economy. Lowering interest rates will adjust the inverted yield curve, enable a more viable model for banks and boost the economy with the not so low probability of inflation returning in one form or another.
A third possibility is proposed by Arthur Hayes, the CIO of Maelstrom Fund, is that in the current economic paradigm and rising rate environment the cost of servicing both short term and (the burgeoning) long-term government debt is net inflationary as interest paid on the debt flowing back into the economy exceeds QT (quantitative tightening). Whether he includes the tightening credit conditions, the bank crisis and inverted yield curve in his calculations is not clear. In his assessment, whether the Fed lowers or raises interest rates in the current economic paradigm, the net impact is inflationary unless the Fed increases its QT which has it's own market risk and consequences.
The net impact of the yield inverted curve and quantitative tightening may offset this thesis but Hayes’s point that the Fed's ability to influence inflation by hiking rates is waning due to servicing an increasing debt obligation at higher rates is valuable and meaningful. It underscores the sensitive balancing act and tightrope the Fed is having to navigate.
Creating an unwieldy oversized debt has been a primary ingredient in the downfall of many empire building nations in history. America’s existing debt burden is projected to add between 1-2 Trillion dollars of new debt every year for the next 10 years. A balanced budget narrative has all but disappeared from the political narrative. And where it does exist in the narrative the "will" to do something about it, does not. The cost of servicing this debt at higher interest rates is impacting monetary policy and to a growing degree, hiking rates to fight inflation is adding significant liquidity back into the system. It is hard to see how servicing growing national debt levels with no foreseeable end that will - if left unchecked - approach 150-300% of GDP can be serviced unless we are in perpetual close to zero interest rate environment. Hardly sound fiscal policy. How far can you kick the can down the road before it kicks back or will self-interest and self-preservation kick in before hand? The dollar has been steadily losing value since the second world war. The current economic trajectory left unchecked will inevitably see a continuation of this trend.
As we have discussed, the Federal Reserve is traversing unchartered territory with a debt burden that has spiralled into new terriotry. The inflation narrative may continue to prevail irrespective of fed policy - whether they hike or cut rates - for reasons outlined herein, which in turn may require or force the Fed to re-set a new “normal” expectation for annual inflation, one that raises the now 2% per annum acceptable rate to 3-3.5% per annum.
While a pause in interest rates may be on the horizon to allow for more data points and time to reveal the current impact of rate hikes, it appears unlikely that we will see rate cuts anytime soon. Further rate hikes cannot be ruled out and as we have discussed these may have contrary inflationary consequences and liquidity moving to higher risk assets in search of not only inflation-risk adjusted returns but currency-devaluation risk adjusted returns as well.