To be perfectly clear (as one discredited President was fond of saying), It would appear that the Treasury has a pretty considerable supply problem that is starting to hit now. Longer dated bonds slid in a serious way late last week and had another bad day today (although the 2 year action went well). And the Fed announced in March that it would buy a $300 billion in Treasuries over the next six months. $50 billion a month isn’t much relative to the burgeoning calendar.
Now we have the “run for the hills” view, with John Taylor (of Taylor rule fame) giving a pretty typical take in “Exploding debt threatens America“:
Under President Barack Obama’s budget plan, the federal debt is exploding,,, The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.
“A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor’s view be incompatible with a triple A rating,” as the risk rating agency stated last week.
I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?
Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years.
Yves here. He just lost tons of credibility. Pull out your trusty HP calculator. it takes a hair over 7% inflation for ten years to double prices. We are supposed to take someone seriously who doesn’t understand compounding, or worse, does, but chooses to argue his point dishonestly to make things sound worse? Oh, he’s a senior fellow at the Hoover Institute. Silly me for asking. Back to the article:
The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably.
Despite the sloppiness, I don’t disagree with the drift of the argument. However, there is a big assumption here, namely, that the Federal government leverage is in addition to Fed/private sector borrowings. If the economy is deleveraging, and the government borrowing is offsetting that effect, it could be salutary (I’d vote for the objective being to dampen the deleveragiing, not to try to counter it fully).
The Wall Street Examiner argues that, contrary to popular opinion, serious deleveraging is happening now, and is also showing up in the Fed’s special faciliites (no online source):
The PDs [Primary Dealers] receive the full benefit of the Fed’s Treasury and Agency purchases since those transactions are directly between the Fed and PDs, while the MBS trades generally are not. They clearly did not use that money to support prices in the Treasury market….
The Fed’s buying was enough to keep a bid under the stock market, but not enough to keep propping Treasuries.
Fed credit outstanding virtually collapsed in the week ended April 29, with reductions in alphabet soup programs outpacing direct Fed purchase of securities by nearly 8 to 1. The biggest reductions were in the major programs, TAF, CPR, PDCF, and currency swaps with FCBs. Banks’ deposits at the Fed were commensurately reduced. The Fed’s lending programs appear to be collapsing because the banks are deleveraging furiously.
The CP market has also shown big declines in outstanding credit. Since this also impacted the Fed’s CPR program, it’s apparent that companies have little interest in borrowing. The Fed is pushing on the proverbial string, but as long as the Fed is pumping cash directly into the veins of the Primary Dealers, there’s a good chance that the stock market will continue to get a bid for the time being. However, I expect that to change as the supply pressure on the Treasury market builds, and as Big Finance and Big Business continue to attempt to raise equity capital and sell junk debt. Under the circumstances if the Fed is unable to prevent the shrinkage of its balance sheet, crisis conditions will return.
Ironically, the media pundits have been worried about exactly the opposite problem—inflation as a result of the Fed not having a plan to reduce its balance sheet when the economy begins to improve. If the Fed’s current bout of shrinkage continues, inflation will be the least of our worries, and we can forget about an economic recovery any time soon…..
The Fed is still pouring cash into the coffers of the PDs, and they are using some of it to buy stocks, hooking a new round of suckers in the process. We need to be vigilant, and be ready to jump off the train at the first sign that it is about to go
back into reverse.
The one bit in the reasoning that isn’t clear to me is how further debt and equity sales, which will entice buyers away from Treasuries, is consistent with deleveraging (unless the missing bit in the logic chain is that even with those actions, the net effect is serious deleveraging). Reader comments encouraged.