Amid the Fed’s balance sheet unwind, the Treasury needs are rising.
The Treasury Department estimated that it will borrow $955 billion in FY 2018, $1.083T in FY 2019 and $1.128T in FY 2020. The budget now seems to be very close to passing the House and be sent to Trump for signing.
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This raises an important question: Where will we get the cash from?
In theory, it should not be a problem for the US government to borrow all the cash it needs. Occasional political antics aside, we are the world’s best credit risk.
No one worries that they won’t get their T-bond principal back. The entire global financial system depends on that rock-solid guarantee.
So, the question is less whether Treasury can repay than whether potential borrowers are healthy enough to supply our needs or might see better alternatives.
Savers and Investors
This question is important because Treasury is losing the Federal Reserve as a primary funding source. Who can take its place? There are several candidates. Unfortunately, each has barriers that may reduce their buying interest.
American savers and investors are prospects if they have money to lend. Unfortunately, the number who do is not growing. It may grow if unemployment stays low and wage growth accelerates. But the Baby Boomers are transitioning from savings mode to spending mode, so they won’t help much.
US pension plans and other institutions that need to fund future obligations are natural Treasury buyers, too. Higher rates might entice back some buyers who have moved into corporate or other long-term bonds in the last decade.
Then again, high enough rates will entice anyone back, but those higher rates come with a cost. On our $22 trillion in total US debt, each 1% higher is about $220 billion in interest as rates go up and the debt has to be rolled over.
That’s interest per year!
That means we are spending approximately 15% of our revenue and 12% of actual expenditures just on interest.
You hear a lot about China’s owning so much of our government debt.
It’s true, but to some degree they have little choice. So long as the US runs a trade deficit with China and we insist on paying for our imports with dollars, China will probably continue to use those dollars to buy dollar assets with that export revenue.
It can happen indirectly: Maybe China buys raw materials from Australia with the dollars, and then the Australians buy dollar assets. But in any case, the amounts are so vast that the Chinese gravitate toward the most liquid dollar asset—Treasury bonds.
China would like to convince its trade partners to deal in renminbi, and the partners are very slowly coming around. This is happening especially through China’s gigantic One Belt, One Road infrastructure initiative. But the simple fact of the matter is that a lot of the projects for One Belt, One Road require the spending of actual dollars.
That Chinese process is unfolding slowly.
I don’t worry about China’s suddenly deciding to boycott US bonds. The Chinese don’t presently have that choice. However, they firmly intend to reduce their dollar dependence wherever possible.
I don’t see them volunteering to lend us significantly more cash than they do now. And indeed, they have been reducing their dollar purchases—significantly.
The reason isn’t complicated. Growing US shale production reduces our need to buy oil from OPEC countries, in the Middle East and elsewhere. We are buying 7 million barrels per day of oil less from outside the US than we used to.
If OPEC countries ship us less oil and gas, we ship them fewer dollars, and they lose capacity to buy our debt, even if they want to.
In fact, federal debt held by foreign investors rose from about $1 trillion in 2001 to around $6 trillion in 2013. But it has more or less gone sideways since that point. China and Japan are no longer buying large amounts of US debt. They’re not selling it, either.
China and Japan and many other foreign countries seem to be saying, “We have enough US bonds; let’s see if we can find some other way to spend our money.”
As you can see, our lender search won’t necessarily be quick or easy. There is one sure way to scare up lenders … but it has a few drawbacks.
The US financial industry is extremely adept at evaluating credit risk for individual borrowers—or at least it thinks it is. Most folks can get a loan if they want one, but your interest rate will reflect your creditworthiness.
Similarly, Treasury can borrow all it needs by paying higher rates. That’s not the preferred outcome, but it is probably what will happen. We are already seeing rates trend upward as the benchmark 10-year climbs toward 3% from near 2% just 8 months ago.
This rise also reflects inflation expectations, but the growing supply of Treasury debt is still the key.
Last week may be just a hint of what is coming. Credit markets are nothing more than borrowers competing against each other for lenders. The Treasury competes with investment-grade corporates, who compete with high-yield issuers.
Then you have municipal bond issuers and many smaller debtors. They all need cash, but there is only so much to go around. Rising Treasury issuance will force other borrowers to pay higher rates, which will in turn make Treasuries buyers demand higher rates.
The process feeds on itself. Borrowers eventually find debt service taking a bigger bite out of their income. This burden leaves them less to spend on other goods and services.
Meanwhile, as time passes, borrowers who locked in lower rates during the QE years will need to refinance and will find they must pay sharply higher rates. Some won’t be able to do so and will go out of business, laying off workers and leaving their own lenders holding losses.
This process will be extreme for issuers of high-yield bonds. As noted last week, there is now a drastically increasing amount of high-yield bond debt that has to be rolled over every year.
That process eventually adds up to a recession, which makes government spending rise even more as people lose jobs. How far away are we from that point? I still don’t expect a recession this year, but the risks will rise as we get into 2019.
From there, the picture worsens quickly.
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