We Didn’t Start the Fire…

The whole world appears to be burning these days. Ukraine remains embroiled in war; the Middle East is erupting (again); mortgage rates hit 8%; inflation; the President is a bit fuzzy; the Republican House can’t find a Speaker; crime is up; the U.S. (and the entire world) is drowning in debt, and if you believe in global warming, none of this matters because there is no hope of the world reducing emissions in time anyway.

If you’re young this feels unique. The older you are, the more this just feels familiar. The late 60’s-early 70’s was a similar time. The Vietnam War; MLK assassinated; RFK assassinated; inflation; Kent State; Watergate. Our world appeared to be falling apart then, too, but somehow, here we are. We are survivors. Like then, the world will be very different in 20, 30, 40 years, but you have to believe that we will still be here. The way out of the collective mess is likely to be hard and totally unpredictable, just as it was back then. As Winston Churchill supposedly said, you can always count on Americans to do the right thing, after they have tried everything else. We are apparently in the ‘everything else’ period.

…It was always burning, since the world’s been turning.


Confused? Welcome to the Club!

I didn’t check, but I feel like I’ve used that line numerous times over the past few years. Interest rates continue to grind higher and everyone wants to know why. Here are some reasons:

  • The economic data is coming in better than expected. That could imply that inflation is not yet under control and will force the Fed to raise rates higher than previously thought.
  • We are in the VERY unusual position of running VERY large fiscal deficits during a period of economic growth. (This level of spending would previously have been typical during a VERY bad recession.) As we saw during the pandemic, too much fiscal stimulus sows the seeds of inflation. Goldman Sachs this week estimated that the U.S. added around $28.5bn of debt per day for 18 days in a row. That translates to $1.2bn per hour and at that rate we would increase the total debt bill by around $1 trillion in less than 6 weeks! And this is before any aid to Israel.
  • Supply and Demand. The Fed is no longer buying Treasuries (no more QE); the Fed is also effectively selling Treasuries (QT); and Treasury bond auctions (bond supply) are ratcheting up in size to fund the growing deficits. Too much supply and not enough demand means prices go down (and bond yields go up when bond prices go down).

Whatever your opinion on this list, all three are at work here. A growing problem is that as rates get higher, the interest costs become a growing concern. That is because interest expense crowds out other discretionary spending in the Federal budget. It’s not long before entitlements (Medicare/Social Security) are on the table, despite the obvious fear elected officials have with that subject. Reducing entitlements is an easy way to get un-elected.

All this is just a long-winded way of saying the current trend continues until something breaks. When that happens, the Fed steps in; QT ends; and QE re-starts, increasing bond demand. The expected result is that the rate increases we have been experiencing are reversed. That appears destined to be the playbook from here. As of today, we are about to set some new, unpleasant records. If nothing changes by year end, the 10-Year Treasury Note will be down for the third year in a row. Based on data back to 1928, this has never happened before. It will also be the worst three-year drawdown by a wide margin. Prior to now, the 3% loss in the 1978-1980 period was the worst for the 10-Yr. Note. The 2021-23 decline is currently about 26%.

We are increasingly worried that the only viable way out of the U.S. debt mess is to de-value the dollar (i.e., inflation). The Fed will stick to the 2% inflation target until it is no longer able. Then the gloves come off. Unless Congress can get a handle on spending, and/or we can have a surge of economic growth, that is the only reasonable conclusion and it is why commodities and inflation protected bonds are looking more attractive to us.


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By: Adam