A Bottomless Pit of Debt

Captain Jerome Powell of Air-Fed has the US economy on final approach for what he hopes will be a “soft landing.”

The phrase “soft landing” (if you’re not familiar, it’s because it’s been shelved for a number of years) means hiking interest rates to cool the economy without crashing us into a recession.

But just in case, he’s warning folks things could get a little turbulent.

Reality is, recession is all but inevitable. He wouldn’t even be talking about “Recession Risk” unless the Fed saw it coming down the pike.

But managing the public’s belief in their ability to actually control inflation is only one problem that the Fed is dealing with. 

Not bankrupting the Government is the other.

Back to the Balance Sheet

In your last letter I told you the Fed was holding roughly $9 trillion in securities on its balance sheet. 

These are assets they’ve purchased to inject (print) capital (money) into the economy. And the Fed  is the US government’s best customer. 

The government issues debt (borrows money) to fund their overspending habit. And repayment of those loans comes with interest. And how do they pay this interest?

By borrowing more money.

This is why it’s very much in the government’s interest for rates to stay low. The cheaper they can borrow money, the lower the total debt burden is when the bill comes due.

Lower rates/yields are the result of a more demand when they auction their debt. Less demand… well, you’ve probably figured out where I’m going. 

Reducing the Fed’s balance sheet by letting its assets “run off” means the Fed will not be participating in future debt auctions. Which means the Treasury department will need to find other buyers to come in and fill the void. At the height of QE, it was estimated that the Fed represented roughly 50% of the bond market’s demand. 

Who’s going to fill that gap?

The Bottomless Pit of Debt

The Federal Reserve has been the Treasury’s most willing lender. They’ll bid treasury markets for the express purpose of keeping rates down. 

But draining the Fed’s balance sheet means that bid goes away. And an article in the Wall Street Journal accurately points out the dilemma:

The Fed can reduce its balance sheet, but that doesn’t mean the federal government can reduce its balance of outstanding debt.

The debt that was amassed is still going to need to be serviced. And the government is still going to have to borrow to do that. The Journal offered some projections:

The CBO in May projected that this year, federal spending on net interest costs would reach $399 billion, compared with $352 billion in 2021, and that the yield on the U.S. 10-year note would average 2.4%, up from 1.4% last year.

(Currently 10-year yields are already trading around 3%.)

And it gets worse as our friends at ZeroHedge point out…

According to the Congressional Budget Office’s latest baseline, interest expense will triple from nearly $400 billion in 2022 to $1.2 trillion in 2032—totaling $8.1 trillion over that horizon. As terrible as that sounds, it’s going to be a major understatement.

That’s because CBO’s Treasury rate assumptions are in the midst of being mugged by reality. For its baseline, CBO assumes the 3-month T-bill rate will average 0.9% this calendar year, but it’s already spiked to 1.69%. Similarly, CBO assumes the 10-year will average 2.4% in 2022 and only rise to 3.8% ten years from now.

With rates soaring, the G’s debt will start deepening exponentially. 

So what?

Well, the government will never default on its debt. It (and the Fed) will always find a way to come up with the cash they need. And coming up with that cash is what’s gotten us to where we are today. 

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily