A Brief History of Debt (and Why it Matters)
The last few weeks have looked a lot like 2022, which was the worst year for the 60/40 portfolio since 1937. I could write a book detailing the missteps of Congress and the Fed that have led us here, but there isn’t time for that, so let’s do a “CliffsNotes” version. As with the original CliffsNotes, this is far from complete, but hopefully you’ll still get the idea.
- In the Beginning – Prior to 1987, Fed interventions had centered on the banking system, raising or lowering short-term interest rates as needed to coax the economy in one direction or another. From 1987 forward, the interventions have become increasingly focused on ‘saving markets’ as opposed to coaxing the economy. In 1987, aside from the usual interest rate measures, the Fed also provided support to the Treasury securities market and rescued of the largest options clearing firm in Chicago. With this first effort to ‘save markets’, the ‘Fed Put’ was born. (The ‘Fed Put’ is the term used to describe the Fed stepping in to buoy markets, especially equity markets, when prices fall too far and/or too fast, just as a put option would do.)
- The Problematic Put. Since then, we have moved from one crisis to the next (Asian crisis/LTCM in the late 90s; the Tech bubble (2000), The Housing Bubble (2008), and most recently, the pandemic). Each time, the steps taken by the Fed became increasingly extreme. While the Put may sound like a very good thing, it has actually created a problem. With each succeeding episode, markets have become accustomed to the Put being there, and often assume it will always be there. This simply encourages speculation, and that leads to more problems. In other words, the Put is a self-reinforcing mechanism that encourages the creation of more asset bubbles. (It’s easier to speculate when you know someone will come to save your posterior.)
- Is the remedy worse than the disease? This series of crises, and the associated remedies, have distorted markets over time. As an example, the housing bubble in the early 2000’s seemed unbelievable at the time, but the recent housing bubble makes it look more like a blip than a bubble. Because of the Fed Put, we now have the bulk of the country with very low rate mortgages and unwilling to move because they will lose the advantage of that low rate mortgage. That matters because although rates are now quite high by recent standards, home prices are not responding as would normally be expected. There is simply too little inventory listed for sale to allow prices to correct. If you need to buy a house, you have very few choices. In short, markets have become distorted and they no longer respond as they normally would. This has been going on for so long, that many of us have grown up with these anomalies and think that what is happening now is normal. It isn’t.
- Don’t Blame Me! It certainly isn’t ‘our’ fault. Just as you would never think twice about taking advantage of a tax loophole, you can’t blame anyone for taking advantage whatever financial situation arises. One problem that we suspect will become more prevalent is that when the Fed intervenes in markets, it only those that own stocks and other assets that can take advantage. It rewards the wealthy, relative to the size of their wealth, and it penalizes those with few or no assets. This growing wealth disparity eventually sows the seeds of discontent. Revolutions occur for a reason, and historically, this is a key reason.
- Getting More Extreme. The housing bubble, which spawned the Great Financial Recession (GFC), has become the posterchild for government ineptitude. The collapse of the economy in late 2008 was blindingly fast and although the Fed responded in the way it always has: it quickly lowered interest rates, this collapse was far too severe and far too fast. Short Term rates were effectively at zero but unable to buoy markets or the economy. Most of the large U.S. banks had to be saved from bankruptcy, and several investment banks disappeared. The Fed then went the next step and implemented Quantitative Easing (QE). All that means is that the Fed, which controls short term rates directly, controls longer term rates by buying bonds in the open market. (More demand = higher prices = lower rates). When this officially began in early 2009, it was supposed to be temporary and fairly short lived. That hasn’t been the case and we would guess that we have been in a QE regime more than 90% of the time since 2009, although we are NOT in a QE regime right now.
- Why so long? Economic policy is guided by monetary policy (controlled by the Fed) and fiscal policy (controlled by Congress). The Fed and Congress are supposed to act in concert, not at odds, with each other, but that is not always the case. Markets were calming down in 2009 and 2010, but the economy was growing very slowly with little inflation and the Fed was very concerned about a deflation returning. For almost the next 10 years, the Fed was pushing very hard on QE but with very little economic growth to show for it. The answer, at the time, should have been some fiscal stimulus, and the Fed, on numerous occasions, prodded Congress to step up to the plate, but Congress declined. As a result, QE became semi-permanent and one could argue that this once esoteric and rarely used strategy might now be considered the baseline policy.
- ‘Wrong Way Corrigan’ Congress. This impasse lasted right up until the pandemic, when Congress passed fiscal stimulus on steroids to coincide with more massive QE from the Fed. So we went from a slowly growing economy with QE and no fiscal stimulus, to a more rapidly growing economy with QE and lots of fiscal stimulus and eventually growing inflation. The Fed and Congress have been 100% out of synch since 2009. While we all enjoyed our stimulus checks at the time, nobody told us the price was inflation.
- Tipping Point. Where is all this money coming from? Great question, the answer is thin air. Just like that household struggling to pay their bills often succumbs to using that credit card for something they want, the U.S. is using its credit card, to the tune of a trillion or two per year. If the U.S. wants to spend it, in theory, taxes must be raised or someone has to lend it to us. Congress isn’t raising taxes, so we sell more Treasury bonds. That sounds simple enough, but it isn’t. China and Japan are historically two very large buyers of Treasuries, but not so much right now. China desires a de-coupling from the U.S. financial system (so any future sanctions won’t be effective) and with rates up around the world, Japan has other more attractive opportunities. The result is that at a time of rising budget deficits, which would normally be financed by selling new Treasury bonds, some of the biggest buyers of Treasuries are walking away.
- The QT problem. QT is simply the reversal of QE. Rather than the Fed buying bonds (and thereby injecting money into the financial system) they are selling bonds (or more accurately allowing the bonds they own mature). In either case, the Fed is paid for those bonds and rather than recycle those funds into buying new bonds, the money is removed from the financial system.
- The Crux of the Current Problem. The biggest buyers of Treasuries are not buying as much as they used to buy; the Fed is not buying (no QE), AND they are selling Treasuries (QT). And this is happening in the face of huge fiscal deficits that demand more bonds be sold. Treasury bond auctions are estimated to be about 25% higher next year! Economics 101 teaches us that less demand and more supply results in lower prices. If you’re a bond, lower prices mean higher yields (rates).
- Pivot Coming? If there aren’t enough buyers for Treasury bonds, something has to give. The Fed cannot influence foreign buying of Treasury bonds, nor can they impact the deficit spending by Congress. The first Fed option is then to allow rates to rise to a level that attracts buyers, but that would essentially assure a recession, and possibly a very bad one at that. The other option is to end the QT regime, which eliminates some selling pressure and reinstate the QE regime and become the ‘buyers of last resort’ for Treasury bonds. This last option seems the most logical path, eventually, but not before higher rates cause some economic pain.
- Deficits and Debt Matter. Interest rates have been incredibly low for more than 10 years and that gives the illusion that debt doesn’t matter because the cost has been de minimis. All that changes when rates rise. Goldman Sachs estimates that Federal net interest expense will rise from 2% of GDP in 2022 to 3% by 2024 and 4% by 2030, crowding out other discretionary spending in the Federal Budget. The important point is that the size of the debt DOES matter and the size of the fiscal deficit DOES matter. It may not appear to matter most of the time, but there is a point where the bond market pushes back and says enough is enough. The evidence this week suggests that we might be approaching that point. The time to ignore budget deficits is behind us.
- The First Law of Holes. The first law of holes is simple: When you are in one, stop digging. The problem, in simple terms, is the U.S. continues to dig. The question is whether we might be so far in the hole, we can’t get out. Our conclusion is that the developing mess will grow until it grows so large that the Fed Put is reached, and we will be back into QE mode. At that point, bonds and stocks hopefully rally, based on the belief that lower rates are at least a temporary answer. If there is a way out, we just haven’t found it yet.
- Economic Soft Landings are Rare. With a few exceptions, the Fed is always trying to engineer a soft landing, they just rarely succeed. Unless the rapid rate increases of the last few weeks are quickly reversed, the current attempt at a soft landing is likely to be a failure as well. Brace for a hard landing.
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