July 28, 2023
Bond Market’s Mirror Image
According to the Congressional Budget Office, the U.S. government posted a $225 billion budget deficit for June, up 156% from a year earlier. This means, the first nine months of fiscal 2023 showed a deficit of $1.4 trillion, which is up 171% from the amount seen during the first nine months of fiscal ’22. Debt service payments are the fastest growing part of the deficit. Interest payments over the last nine months reached $652 billion, and are projected to grow by 39% from fiscal 2022. Interestingly, revenues fell 11% in the comparative period, which begs the question; if the economy is really growing, then why are tax revenues shrinking? The answer is, all we are actually measuring is nominal growth due to inflation…there is no real growth at all.
The U.S. debt is officially $32.6 trillion. However, the true size of government debts, including entitlement obligations such as Social Security and Medicare, is around $200 trillion. According to the estimates from the Congressional Budget Office, entitlements and interest expenses alone will equate to 100% of all taxes by 2040. The legendary investor Stan Druckenmiller frames it like this, by 2040, there will be no money left for defense, nothing to spend on any welfare programs, and no funds left to run any part of government. Of course, no government can operate without money—that is why they all own a printing press.
To make things worse, the Fed normally remits its profits made on government debt back to the Treasury. However, that is no longer the case because the Fed is now losing money. It pays more on RRP agreements and excess reserves than it earns on its Treasury and MBS holdings. According to my friend Chris Whalen of Whalen Global Advisors, the losses being incurred by the Fed means that the central bank will not be remitting any savings to the US Treasury for the next decade. “The Fed is on the way to operating losses of an estimated $110bn this year,” writes Alex Pollock. “Its mark to market loss as of March 31, 2023, was $911bn.”
So, there are only three solutions on the table, massive spending cuts, humongous tax increases, or hyperinflation. All of which are extremely deleterious to the economy, but tax increases and spending cuts are politically untenable, and the economic damage incurred from either would engender depression in the short term—these are the only sustainable solutions. Hence, the Fed will most likely try to print the problem away. Remember, both parties just had a huge debate about raising the debt ceiling, and in the end, decided entitlements and defense spending were off the table. .
Hence, the Fed will most likely try to print the problem away. Hyperinflation is not at all a panacea either; but it can be obfuscated much more readily than a depression.
Therefore, after this current bout to fight inflation ends in an economic and asset price meltdown—as has been in the past—the Fed will eventually resort to another round of massive Quantitative Easing. After all, debt and deficits always spike during a recession. Only this time around, rather than having the government in a state of fiscal prudence, we have one that is already hemorrhaging red ink and heading for insolvency…if not already there.
This means Powell will be forced to increase the Fed’s balance sheet once again by multiple trillions of dollars as he monetizes all the government debt needed to re-liquify the banking system and Treasury market. We know he will do this because of his history. When just a few banks failed in March of this year, Jerome Powell, without hesitation, printed $400 billion, backstopped all FDIC depositors, and offered to buy all banks’ MBS and Treasury assets at par and hold them for a year—regardless of their worth. It is called the Bank Term Funding Program, and it bailed out the entire banking system.
We can be assured that revenue to the Treasury tumbles during a recession. We also know that expenditures surge as the automatic economic stabilizers kick in. This means the Fed’s balance sheet will explode higher. And, as banks dump all of their troubled assets on the Fed, Powell’s printing press will need to go on overdrive.
Hence, on the other side of this coming recession—and after its concomitant reflex bond-buying spree ends—look for bonds to enter a secular bear market, which should be the opposite image of the great multiple-decade bond bull that began in 1981.