Bonds And Money

The US bond market is getting hammered lately as investors and traders realize that (a) the economy is not collapsing and (b) the Fed will keep rates high for longer than previously anticipated.

Money creation is THE driving force of consumer spending which is, by far, the most important component of US GDP. 

So, here is a chart of “money creation” via the Fed’s own balance sheet. Assets are now at 32% of GDP, up from 18% pre-COVID and just 6% before the Great Debt Crisis.

In both cases the government/Fed just threw money at the problem instead of handling it in a more constructive and structural fashion.  If the current situation evolves into yet another crisis, this time printing money will definitely create much bigger problems than it solves: to wit, hyperinflation and the end of empire.

The chart is another way to measure the devaluation of the dollar vs “real” assets and economic activity. The rest of the global economy is also “devaluing” (eg the EU/euro and recently Japan/yen) so as of yet there are no credible alternatives.  But watch out for China…

Debt To GDP For The US - We Have A Winner!

Note: Numbers on Debt/GDP below have been calculated using GDP on a Purchasing Power Parity (PPP) basis.  Also, I have removed countries such as Lebanon, Suriname, Sudan, etc. from the chart.

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When it comes to Debt/GDP Japan is the undisputed "champion" - but most all of its debt is domestic. Only 6.5% of all debt is owed to foreigners, while the vast majority (52%) is held by the Bank of Japan. This has significant global repercussions, but Japan is not my subject today.

Number two on the rogues list is Greece - no surprise there - but unlike Japan most all of its debt is owed to foreign official sector lenders. The bad news here is that this debt load exists even after the country went bankrupt a decade ago and plunged its economy into a decade long depression. But Greece is also not my subject today.

Numero tre is Italy.  A perennial problem child, the only reason Italy can still finance itself at reasonable interest rates is that its Eurozone membership is presumed to preclude a bankruptcy. Let me point out, however, that as recently as 2008 its debt/GDP(PPP) was ca. 70%.  But Italy, too, is not my subject today.

My subject today is the USA - not a shock to regular readers of this blog going back as far as 2006.  And my main question here is this: how logical, or even safe for the global economy, is it that the issuer of the world's reserve currency is so heavily in debt?  Indeed, what does this mean for the US dollar when its issuer is the world's #4 most indebted economy? 

Sure, under our current fiat currency regime, where debt is money and money is debt, it is expected that the availability of the global reserve currency can only come from a country that has a commensurately high debt.  

But at which point does the debt load finances mostly domestic consumer spending of cheap imports (eg China) and defense spending, instead of productive, high value added activities? At which point does the incessant printing/borrowing become a vicious cycle? 

Hint: the crypto boom is stoked to a large extent by those who look at such statistics and rub their hands in glee.  I do not share their glee because if we go down that route we are opening a much worse Pandora's Box - no need to enumerate all the nasty stuff that will come out from the Crypto Box.

But... something must be done to contain the US propensity to borrow and spend with abandon as if "tomorrow never comes, la, la, la".  Because, unlike in the song, tomorrow always comes.

Let me try to quantify the debt excess, even if roughly: the US accounts for approx. 16% of global GDP(PPP), but its government debt stands at ca. 35% of global government debt.  In other words, the US is twice as indebted when measured against its global economic size. 

US Inflation And The Fed

 The one certainty from Mr Powell’s Jackson Hole speech a couple days ago is this: The Fed remains firmly committed to its 2% inflation target. Corollary: all policy decisions will stem from that.

I’ve put together a chart comparing headline, core and employment cost inflation - see below. My interpretation of the data is this: headline inflation may have come down sharply due to an outsize drop  in energy prices, but core and employment cost inflation are still more than double the Fed’s target.

Those expecting a quick reversal of high interest rates and restrictive monetary conditions (QT) are going to be very disappointed - unless a severe recession hits. Either way, not ideal for debt and equity markets.

Charting Tealeaves

 In my experience, charting as a market analysis tool is as useful as reading tealeaves.  But, occasionally it actually works, so when I have nothing better to do I look at charts for those familiar patterns which, purportedly, foretell the future.

I have nothing better to do right now (dog days of summer), so here's an annotated chart of SP500. The chart pattern is called an inverted flag (a bearish "trend continuation") and, theoretically, a downward breach of the flag signals a continued downward move to at least as low as the length of the pole from the point of the breach.

How do you take your tea? I recommend large doses of grains of salt... :) .  Nevertheless, as I said in my previous posts, the bond market - which I strongly believe is a very good warning indicator - is looking decidedly ugly, so maybe this time the tea leaves are issuing a valid reading.

Maybe The Real Reason Bond Prices Are Dropping Is...

 Analysts are somewhat baffled by the drop in bond prices.  Inflation is moderating and the Fed is sending "hold" messages. So what is driving bond prices to 20 year lows?

Maybe - just maybe - it's the oldest reason in finance: creditworthiness.  After all, Fitch just downgraded the US from AAA to AA+. 

Just how creditworthy is the US? 

In just 4 years the US has raised its gross Treasury issuance from $12 trillion to a projected $21 trillion in 2023. Yes, it's not net issuance (ie after maturities/debt retirement), but bear with me for a bit.  Gross issuance has gone from 50% of GDP in 2018 to 77% of GDP in 2023P - see charts below.

Why am I choosing gross issuance instead of net? Because if the US were to become less creditworthy (and it arguably has) some lenders could balk at rolling over their existing bond investments and/or demand a higher return.

I think this is exactly what is happening right now: increased supply (more gross issuance) is starting to face demand headwinds causing prices to drop.

Gross bond issuance is also a measure of debt service stress.  Since the government is running massive budget deficits, it has to issue debt to cover that plus interest payments.  And as interest rates rise, so does the amount of new debt required to pay just interest.

Take a look at the chart below: in just a few months, the federal government's annual interest payments have soared from $500 billion to nearly $1 trillion.  

Is this sustainable? Is it compatible with even a lower AA+ rating?  From one perspective, it is: interest payments as a percentage of GDP have jumped from 2.5% to 3.6% (1Q23), but still well below the highs of the 1980s - see chart below.

Interest Expense as % of GDP

However, when we look at the budget deficit, things become scarier - see chart below.  The FY 2023 deficit is projected to reach well over $1.5 trillion, perhaps even reach $2 trillion.  In just the first 9 months from October 2022 to June 2023 the deficit stood already at $1.4 trillion, fueled in large part by the soaring interest expense discussed above.

US Federal Budget Deficit (FY 2022 Last Point On Chart)

In sum, the US government finances are, in a word, unsustainable. Unless:

(a) the budget deficit is slashed and,

(b) interest expense comes sharply down

even the AA+ rating is very generous, optimistic and likely to go lower quickly.  In my opinion, Fitch's action is a first warning - I bet they wanted to go lower but chose to be politically cautious, at first.

The Trillion Dollar Question

A one question post today:

• Given its enormous debt load and the spike in interest rates driving debt service closer to unsustainable levels, which is in the US government's interest?

a) A sharp recession to drive interest rates down.

b) Robust economic growth.

Comment freely.

More Trouble Ahead From Bonds

I don't think most people realize the massive losses that have been suffered by bond investors in the last year and a half - take a look at the chart below.

                                                30-Year Treasury Bond Prices 

The US 30-year Treasury bond was at 156 points as recently as January 2022 (and as high as 180 in mid-2020);  today it has collapsed to 118.  Ignoring the 2020 COVID-induced high, bond investors are suffering a staggering mark to market loss of 25% in just 20 months.  This is not a loss normally associated with the presumed safety of Treasury bond investments.  Even worse, it has happened fast - it is the sharpest price drop since at least 1977.

So what, you may ask?  Bonds are the preferred investment for banks, insurance companies and pension funds.  They usually make up well over 70% of their portfolios, one way or another (eg home mortgages are regularly packaged into long term pass-through securities such as Ginnie Maes).  And while such investors may choose to place long bonds into their "investment/hold to maturity" portfolios, to shield them from having to recognize mark-to-market losses in their books, that's just an accounting trick.

Reality, however, can never be avoided for long.  Rating agencies are already downgrading US banks, for example.  Given the persistence of inflation, pension funds are coming under uncreased pressure to raise pensions, particularly government entities.  And insurance companies must be worried about more natural disaster claims as global climate change is occurring much faster than anyone thought.  All of that means that traditional bond investors may have to sell positions in order to meet liquidity demands.

And I haven't even touched on the subject of much higher borrowing and refinancing costs for governments and businesses.  In brief, the entire world had become grossly and unhealthily addicted on ultra-low interest rates for the past 10+ years.  It is now discovering that money is not free, or even cheap.

The Bond Market Is Sending A Warning

 Those of us who are, or were, active in the professional/wholesale side of markets (eg interbank) know very well that bond markets lord over all other markets.  The daily trading volume of the US bond market is simply enormous: just amongst primary dealers daily volume averages around $750 billion for Treasury securities alone.  Add the rest of the participants, corporate and muni bonds, throw in repo and you're up to well over $2 trillion changing hands every day. Compare this to the US equity market at around $200 billion per day and you get the picture.

Therefore, what goes on in bonds is extremely important, not only because interest rates are paramount in our economy but also because size matters! - and it matters alot.

Bonds are now looking rather worrisome.  Take a look at the yield on 30-year Treasurys - chart below.  At 4.44%, the yield is at, or very near, 12 year highs. I don't care what equity analysts say, the real pros are sending us serious warning signals.

US Treasury 30-Year Bond Yield

The thing that is truly worrisome, from a long term perspective, is that bond prices have broken down from their very long term up channel going back 40 years - see below.  If you are a chartist - and many  pros are - this chart looks scary. VERY scary. 

Why, Oh Wise One?

 Berkshire Hathaway, Mr. Buffett's primary investment vehicle, has investments in 56 publicly traded companies.  Yet, just one (Apple) makes up a massive 51% of its holdings by market value.  Another seven make up an additional 34%, for a total of 89% (see below).

So, Berkshire is essentially a proxy for Apple, plus a very, very few more stocks.  OK, so Mr. Buffett is not bound by the usual rules for portfolio diversification... but still... WHY has he decided to turn Berkshire into such an incredibly NON-diversified investment vehicle?

Honestly, I don't understand it.  Can any reader please comment?

Thanks!

Inflation Warning

 Inflation has come down fast from its highs… but! It’s all due to sharply lower energy prices - see chart below. If it wasn’t for energy (ie oil prices tumbling) inflation today would be at 5% or higher.

And why did oil prices tumble? Almost entirely because the US drained its Strategic Petroleum Reserve down to levels last seen in 1983-84. Within just a few months the government sold a massive 300 million barrels of crude oil, causing prices to tumble - see chart below.

Sales from the SPR have now stopped and - shock! - crude oil prices are climbing once again, going from $73 to $83 per barrel in the last 30 days. Not surprisingly, gasoline futures are trading at $2.95/gallon, the highest level in 12 months. Even more ominously, 30 year Treasury bond yields are at 4.24% very near the highest level in 20 years.

It doesn’t take a degree in economics to guess where inflation is headed next…or what this means for markets.