Economy
Digital Currencies and US Dollar Dominance
Since the use of physical cash was already in decline even in 2018, the BIS went on to consider the benefit of CBDCs as a means of bypassing the banking system and delivering money directly to the general public.
Since the Great Financial Crisis in 2008, cryptocurrencies have come of age. The advent of Bitcoin in 2009 is often thought to have been the beginning of cryptocurrencies, but as early as 1983, American Cryptographer David Chaum had invented the blinding formula, an extension of the RSA algorithm which is still used today for web encryption. Chaum went on to create DigiCash in 1989.
The backbone of modern cryptocurrencies is distributed ledger technology (DLT), which developed out of the public key infrastructure of the early 1990’s. There are numerous reasons why it took so long for cryptocurrencies to gain traction, but the financial crisis of 2008 was undoubtedly a catalyst. It was a crisis of trust; trust in the banking system, trust in the honesty of public institutions, trust in the value of fiat money itself. In the aftermath of the crisis, gold, along with other stores of value, rose in price, but Bitcoin, endowed with anonymity and a finite money supply, captured the imagination of a new generation of investors for whom gold was a technologically barbarous relic.
Of course, the anonymity of a public ledger also led to Bitcoin – and other cryptocurrencies – being used by criminals seeking to hide the proceeds of their illicit activities from the authorities. In the early days of Bitcoin adoption, many commentators anticipated that the authorities would outlaw its use, driving it underground. Perhaps because of its structure and the global nature of the internet, the authorities chose not to act in haste. Instead they observed and learned.
Today regulators and their governments are starting to prosecute crypto-criminals. Despite the anonymity of encryption, cryptocurrency seizures are on the rise, but at the same time central banks are preparing to launch their own digital currencies.
It is the implications of this development that I want to investigate in this article. To understand the motivation for the introduction of central bank digital currency (CBDC) one needs to look first at the evolution of the current fiat money system.
Prior to WWI the majority of developed nations linked their currencies to the price of gold. This was the era of the original Gold Standard. During the Great War the countries of Europe abandoned the Gold Standard and debased their currencies in order to finance the war to end all wars. The US benefited economically, selling goods to the allies who in turn made payment in gold or government debt. At the outbreak of WWI, Sterling had been the preeminent reserve currency; by 1918 the US Dollar had assumed preeminence.
During the interwar years, the US continued to supply goods to Europe. With the outbreak of WWII the flow of gold to the US accelerated to such an extent that the US acquired the vast majority of the world’s gold reserves. A return to the Gold Standard, after hostilities ended in 1945, was simply impractical.
The year 1944 saw a meeting at Bretton Woods, New York, which led, with the ending of the war, to the introduction of the Gold Exchange Standard. Under this system gold reserves were replaced by US Dollar reserves. The Gold Exchange Standard, in its turn, collapsed in 1971, ushering in the era of fiat currencies, backed by the tax-raising capacity of each nation. Nonetheless, today more than 60% of all foreign bank reserves are still held in US Dollar cash or US Treasury securities. The Dollar remains the world’s reserve currency, but the recent pandemic has weakened its allure as a store of value, in part because the US government, abetted by its central bank, has expanded the monetary base to combat the combined supply and demand shock to the US economy.
Of course, this rapid expansion of the monetary base has had multiple side effects. In their semi-annual, report to Congress, published this month and entitled, Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States, the US Treasury states: –
Over the four quarters through June 2020, a number of economies have experienced significant expansions in their current account surpluses, including China, Taiwan, and Vietnam, while other countries, including Germany and Switzerland, have maintained large trade and current account surpluses, which allowed for external asset stock positions to widen further.
Not content with an improved current account position with the US, a number of countries have doubled down, following the US lead as they race to debase their own fiat currencies. For most nations, however, what French Finance Minister Valery Giscard d’Estaing described in 1969 as the ‘exorbitant privilege’ bestowed upon the nation whose currency enjoys reserve status, means there is always enthusiasm for a viable alternative to the US Dollar.
Since the Great Financial Crisis, central bank gold reserves have risen rapidly. The chart below shows the main countries which have sought to diversify away from the US Dollar: –
China, the world’s second largest economy, has seen its foreign exchange reserves increase again during the last year. The composition of those reserves is not frequently disclosed but in 2019 the Chinese State Administration of Foreign Exchange announced that as at the end of 2014, US Dollar assets accounted for only 58% of their reserves, down from 79% in 2005. Since October 2016, when the Chinese Renminbi (RMB) became a constituent, the Chinese have volubly favoured the adoption of the IMF Special Drawing Right (XDR) – a statement of account rather than a tradable currency – as an alternative to simply holding US Dollars. Having been incorporated in the XDR, China anticipated that the RMB would quickly see its secondary reserve currency status grow, but as of April of this year, official reserves of RMB amounted to a mere $221bln, less than 2% of total central bank reserves. For China, their inability to promote the RMB as an alternative to the US$ has perhaps prompted other initiatives.
One such initiative is the introduction of digital currency electronic payment (DCEP), China’s name for their CBDC. The Chinese economy is well-positioned for such an innovation, as applications such as Alipay or WeChat Pay, together with the near ubiquity of the smartphone throughout China, means that digital payment is preferred to cash – in 2018 83% of payments were made through mobile devices. That figure is estimated to have reached 93% today.
The DCEP trial, launched in April, has been taking place in the cities of Shenzhen, Suzhou, Chengdu, and Xiong’an. It is cheaper and easier to use (and issue) than physical money and gives the authorities much greater control, both domestically and abroad. Every transaction can be audited, tax avoidance will be far more difficult and exchange controls can be more effectively enforced. If, during a crisis, the banking system should cease to function, the central bank could even deliver cash (or credit) directly to individuals.
The new currency does not come without risks to the incumbent system. For the individual, holding cash, securely in digital form, obviates the need for banks as deposit holders. If the banks have no deposits, their ability to lend is dramatically curtailed.
The international financial system could also be transformed. A digital RMB could eventually allow payment to sanction-bound countries without it having to pass through the dollar-based international payments systems.
At the beginning of December, Russia announced that a Digital Ruble will be introduced next year. The exact specifications are yet to be declared, but state control of the medium of exchange seems to be central to the endeavour. It has yet to be decided whether the Digital Ruble will be made available through the current banking system or provided directly to individuals. Russian bankers remain nervous!
Interest in CBDC is more widespread than just China and Russia. A survey published earlier this year by the Bank for International Settlements (BIS) found that 53 out of 66 central banks were considering digital currencies. The BIS Markets Committee on Payments and Market Infrastructures published a working paper on the subject in March 2018, simply entitled Central bank digital currencies. Among their observations was the question of, design choice; should its access be wide or restricted, wholesale or general purpose; the degree of anonymity; operational availability (24/7 or less); and whether or not to make it interest bearing.
The authors went on to look at the role of central banks, noting that in the current fiat currency marketplace they tend to restrict access to digital money whilst making physical cash widely available. They then discussed the benefits of DLT for the settlement of wholesale CBDC transactions, highlighting the capacity constraints and questioning DLT’s supposed technological advantage – much has changed since 2018 in that regard.
Since the use of physical cash was already in decline even in 2018, the BIS went on to consider the benefit of CBDCs as a means of bypassing the banking system and delivering money directly to the general public. Their enthusiasm was qualified and they asked whether there might be better means of achieving such goals, especially when fast and efficient private, retail payment products were already available. The authors recognised that digital money could (especially in a crisis) circulate even faster than traditional electronic cash, requiring central banks to react more quickly to rapidly changing demand for a broader range of eligible ‘good collateral’ assets. This again raised the issue of the disintermediation of the commercial banking system. Why should one bother having a checking account with a limited liability bank when you could avail yourself of the services of a friendly neighbourhood central bank?
The BIS then considered the benefits of nonanonymous CBDCs, allowing for digital records and traces, which would improve the application of rules aimed at anti-money laundering. Then, in stark contrast, they peered into the abyss, contemplating anonymous general purpose CBDCs, which could be a near and present danger, especially since these currencies would not be limited to retail payments and might become widely used globally, not just for nefarious transactions, but as a form of economic warfare. Economic sanctions against rogue states, for example, would be rendered entirely toothless.
Finally the authors’ opined on the need to monitor the development in digital technology and payments, noting the emergence of private digital tokens which would be neither the liability of any individual or institution and backed by no nation, nor any corporate authority. Their unspoken concern was of a challenge to the current order should the price of these private tokens become less volatile and investor protection improve. A common means of payment, which is both a stable store of value and a transparent unit of account could pose a real threat to the dominance of all fiat currencies. For the present Stablecoins, linked to the value of fiat currencies, fulfil this function, but with companies, such as Facebook, proposing to introduce their own currencies, an alternative means of exchange could quickly emerge.
Bringing the CBDC discussion up to date, the IMF – Glaciers of Global Finance: The Currency Composition of Central Banks’ Reserve Holdingspublished this month, discusses the change in the pace of digital transformation, the shortening of global supply chains – which reduces the need for the world’s principal reserve currencies. They focus also on the increased issuance of domestic currency denominated government debt by emerging economies. All these factors combine to reduce international reliance on the US Dollar, Euro, Yen and Sterling – to list the four most traded reserve currencies. The recently signed Regional Comprehensive Economic Partnership, a free trade agreement between Australia, Brunei, Cambodia, China, Indonesia, Japan, Laos, Malaysia, Myanmar, New Zealand, the Philippines, Singapore, South Korea, Thailand, and Vietnam, can only serve to further diminish demand for US Dollars as a medium of exchange.
The IMF authors conclude: –
There is currently no sign of major shifts in the composition of central bank reserve currencies. However, the glacial pace of change over recent decades should not be taken as an indication of the future.
The risk of an evolutionary leap forward to a multipolar world without a natural reserve currency may be closer than many commentators think. In November 2019, the Belfer Center, Economic Diplomacy Initiative, suggested the following scenario in Digital Currency Wars – A National Security Crisis Simulation: –
In the not-so-distant future, China becomes the first major economy to issue a central bank digital currency (CBDC). The development goes largely unnoticed at first, since payments in China are already highly digitized. Then, North Korea tests a nuclear missile that demonstrates significant advancements in its nuclear program. Analysts believe it could land a nuclear weapon in the continental United States within a year. These capabilities, it turns out, are funded using the Chinese digital currency, which U.S. authorities cannot track. Soon thereafter, countries that want to escape U.S. oversight and sanctions, like Russia and Iran, begin issuing their own digital currencies.
As the world watches the Chinese experiment with its DCEP, which is planned to be rolled out across China in time for the Winter Olympics in February 2022, the Digital Currency market looks set to bifurcate into state-sponsored currencies which give their issuers greater control and private coins, backed by no authority – although some will have an underlying intrinsic asset value. There will also be, as of now, anonymous and non-anonymous offerings, both from private and public issuers. A US CBDC is inevitable, if the US government does not want to be left behind.
Is this the end for the US Dollar as the world’s reserve currency? As Churchill might have said, ‘…This is not the end. It is not even the beginning of the end, but it is, perhaps, the end of the beginning.’
Economy
McMaken: The Fed’s Inflation Is Behind the Supply-Chain Mess
… the idea that supply chain problems are “driving inflation” gets the causation backward.
It seems supporters of the Biden Administration finally settled on a narrative they like for explaining away supply chain shortages.
Here’s the administration’s talking point: the US economy is rolling along so well that Americans are demanding huge amounts of goods. That’s overwhelming the supply chain and causing the back-ups roiling America’s ports and logistic infrastructure.
For example, Transportation Secretary Buttigieg this month declared “Demand is up … because income is up, because the president has successfully guided this economy out of the teeth of a terrifying recession.”
Similarly, White House spokeswoman Jen Psaki told reporters supply chain problems are occurring because “people have more money … their wages are up…“we’ve seen an economic recovery that is underway…”
This position has been mocked by a number of conservative politicians—including Senator Ted Cruz—and commentators who find this to be an absurd assumption.
Yet, the administrator’s defenders aren’t totally wrong. As Mihai Macovei showed earlier this month, the global volume of trade and shipping volume in 2021 have actually exceeded pre-pandemic numbers. For example, in the port of Los Angeles, “loaded imports” and “total imports” for the 2020-2021 fiscal year (ending June 30, 2021) were both up when compared to the same period of the 2018-2019 fiscal year.
In other words, it’s not as if nothing’s moving through these ports. In fact, more is moving through them than ever before. That suggests demand is indeed higher.
But why is it higher? It some ways, it’s true that, as Psaki says, people have more money.
But that’s where the veracity and usefulness of Biden’s defenders end in explaining the problem.
Much of the answer can be found in monetary inflation. Obviously, Joe Biden hasn’t “successfully guided the economy” through anything, but it is accurate to say that people have more money in a nominal sense. Wages are up nominally. After all, if we look at the immense amount of new money created over the past 18 months, we should absolutely expect people to have more money sloshing around. But this also means a lot more pressure on the logistical infrastructure as people buy up more consumer goods.
In other words, the idea that supply chain problems are “driving inflation” gets the causation backward. It’s money-supply inflation that’s causing much of the supply chain’s problems. Not the other way around.
After all, since February 2020, M2 has increased from $15.2 trillion to $20.9 trillion in September 2021. That’s an increase of 35 percent. Yes, some of that has been kept within the banking system through the Fed’s payment of interest on reserves, but a lot of it clearly has entered the “real economy” through stimulus payments, unemployment insurance, and federal deficit spending in general.
Originally, the public was saving a lot of that stimulus and bailout money, with the personal savings rate hitting historic highs of over 25 percent. But this past summer the savings rate collapsed again, and as of September is back under eight percent. The public is now flooding the economy with its former savings.
The American appetite for spending on consumer goods hasn’t gone away. Yet, there are many reasons to suspect this spending spree is unsupported by actual economic activity, and in a phenomenon of monetary inflation.
For example, today’s tsunami of spending raises questions when we consider there are still about five million fewer people working in the American economy than was the case in early 2020. That means fewer people being paid wages. Without monetary inflation, an economy with millions of fewer workers suggests there should be less spending.
Additionally, spending increases when the public suspects that inflation is going to increase. That is, if there is perception the value of money will decline, the demand for money will decline also. As Ludwig von Mises noted: “once public opinion is convinced … the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size.”
That means more spending. This phenomenon is already clear in home prices and grocery prices. The public may suspect rising prices are here to stay. Meanwhile, the Consumer Price Index—a very limited measure of goods-price inflation—is nonetheless near a 35-year high. That means now’s a good time to spend.
With 2020’s panic-induced saving subsiding, people are now wondering if their savings produce any returns. But ordinary savers are surely now remembering that the interest returns from savings right now are next to nothing. Thanks to the central bank’s ultra-low interest rate policy, we live in a yield-starved world. That’s OK for hedge funders who can participate in carry trades and other high-yield forms of investment. But for regular people they’re stuck with interest rates that don’t keep up with price inflation. So it makes more sense to spend dollars rather than save them.
So, Biden’s people are correct in a certain sense that people have “more money” and that “demand is up.” With federal spending hitting historic highs—and half of it is deficit spending that’s being monetized—we should expect people to have “more money.” This is just what we would expect in an inflationary environment. We should expect demand for everything (but money) to be up.
The question, however, is how much of this windfall will continue in real, inflation-adjusted terms. It’s too early to tell, although we can also see that inflation-adjusted median earnings collapsed 6.3 percent, year over year, during the second quarter of 2021. We can see that real GDP growth has dramatically slowed.
But at least as far as the third quarter is concerned, it’s fairly clear the US was—and likely still is—in the midst of an inflationary boom. But how long will it last?
Economy
There Are Still Over 14 Million Americans On Some Form Of Government Dole
… we remind readers of the gaping chasm between those still claiming some form of pandemic-related unemployment benefit and the record number of job openings in America currently…
Initial jobless claims hovered at post-COVID-lockdown lows but were disappointing at 373k – well above the 200k-ish norms of pre-COVID
Source: Bloomberg
Notably, California and Virginia ‘estimated’ their jobless claims last week and Pennsylvania continues to swing wildly from week to week…
But, while the picture is improving overall, we should still remember that there are over 14 million Americans still on some of government dole…
Source: Bloomberg
We do note that 460k Americans dropped off the pandemic emergency aid rolls…
Finally, we remind readers of the gaping chasm between those still claiming some form of pandemic-related unemployment benefit and the record number of job openings in America currently…
Source: Bloomberg
Tick-tock on those benefits.
Economy
The Fed in a Box Part 2: They Cannot End Quantitative Easing
If inflation doesn’t slow in the coming months, the Fed may be forced to step in.
- If the Fed tapers QE, it may reveal waning appetite for long-term treasuries
- The Treasury may have used its cash balance reserve to anchor inflation expectations
- If inflation persists, the Fed may have to increase rather than decrease QE
Note: By definition, inflation is an expansion of the money supply. In this article, inflation will be used interchangeably with rising prices (usually as a result of money supply expansion)
Introduction
When the economy was shut down in March 2020, the government responded with massive fiscal and monetary support. The fiscal stimulus totaled $4T+ in relief packages. All of this spending was paid for with debt issued by the Treasury. The Treasury mostly issued short-term debt. With rates being held at zero by the Fed, and strong demand for short-term debt, it made sense to quickly raise cash using Treasury Bills as interest-free loans.
The Fed monetary policy was two fold, slash short-term rates to zero and inject $1.5 trillion into the long-term debt treasury market. The effect was to bring down interest rates across the entire yield curve. After the initial debt binge, QE went on auto-pilot, with the central bank buying about $80B a month in long-term debt (plus another $40B in Mortgage debt). Over the last year, the Treasury has continued to issue long-term debt, averaging more than the $80B the Fed has been buying. This has caused long-term rates to rise.
All of this fiscal and monetary stimulus is not without cost. Historically this type of activity almost always leads to higher inflation. The Fed may have recently indicated it wants higher inflation, but this is not true. This stance simply provides cover for them to not act in the face of rising prices. To actually fight inflation, the Fed would have to increase short-term rates above the rate of inflation. Part 1 of this series went into detail about how US short-term debt has doubled from $2.5T to $4.5T. This makes even small changes in short-term rates an immediate risk to the federal government, not to mention the much higher rates needed in a true inflation fight.
In theory, the Fed could leave short-term rates at 0% while ending QE and even shrinking its balance sheet. This would push long-term rates up to combat inflation. In the short/medium term the Treasury can mathematically handle higher long-term rates because it takes time for the higher rates to work their way through long-term debt. See the chart below that shows how the last tightening cycle worked its way through the average interest rate across debt instrument. Specifically, look at Notes compared to Bills. The average weighted interest rate on Bills moved very quickly where the rate on Notes barely had time to increase before rates dropped again.
Source – Treasurydirect.gov
Although the Treasury could handle rising long-term rates (even if the economy and mortgage market cannot), the Fed has another problem. Rising long-term rates send an important message: rising inflation expectations. While inflation is first and foremost a result of monetary policy, higher inflation expectations quickly exacerbate the problem. This is why the Fed has been messaging they are OK with higher inflation and also why they have been pounding the table that inflation is transitory. They need to keep inflation expectations low! If inflation expectations were to rise, especially at this critical juncture, it would be game over for the Fed, as they would have to raise short-term rates (devastating the Treasury and economy) in order to save the dollar and squash inflation.
With the economy opening up in March of this year, things were getting very precarious as inflation was rapidly rising along with surging long-term rates. Remember that rising long-term rates indicate rising inflation expectations. This could cause transitory inflation to be much less transitory.
In summer 2020, the Treasury issued enough debt to build up a significant cash reserve. In response to rising long-term rates in Q1 2021, it appears the Treasury strategically used its cash reserves to slow down the issuance of long-term debt. With total short-term debt outstanding already so high, the cash balance gave the Treasury ammunition to decrease debt issuance just as a $1.9T stimulus bill was passed and inflation was set to explode higher. This would have been perfect timing to support the Feds narrative that inflation is transitory to keep expectations from snowballing out of control.
If inflation doesn’t slow in the coming months, the Fed may be forced to step in. With the Treasury poised to issue more debt, it can no longer rely on its one-time use of excess cash reserves. This will put more pressure on the Fed to clamp down long-term rates by increasing rather than decreasing QE. Yes, the Fed may decide to print more money (leading to higher prices) to fight rising inflation expectations (higher long-term interest rates).
Understanding recent fiscal and monetary maneuvers
Last year, when the pandemic hit, the US Government started spending trillions of dollars. Massive spending plans were approved in the name of stimulus and COVID relief. Because the government does not have much money on hand, and taxes cannot quickly be raised, the Treasury issued trillions in debt. The markets can easily absorb short-term US Treasury Bills, so when the Fed abruptly cut rates to 0%, the Treasury responded by issuing short-term debt to the tune of $2.4T from March to June 2020. See figure 1 below.
Source – Treasurydirect.gov
In tandem, the Fed bought up trillions of dollars in US Debt, but the Fed was buying on the long end of the curve while the Treasury was issuing debt on the short end. This caused long-term rates to collapse. The Fed purchased enough long-term debt to absorb more than a year’s worth of long-term debt issuance. The chart below shows how the month over month and cumulative change in the Feds balance sheet compared to the Treasury Debt Issuance of long-term notes and bonds.
Source – Treasurydirect.gov
This action by the Fed had a massive impact on long-term rates. The chart below shows the difference between the two bars above, specifically the difference in Fed Buying and Treasury issuance of long-term debt for each individual month since Jan 2020. These values are not cumulative. The right Y-Axis shows the month-end interest rate of the 10-year bond. Looking at this chart shows something extremely clear: When the Fed buying exceeds debt issuance, rates are flat or falling; however when long-term debt issuance surpasses the Fed’s buying, rates rise.
Source – Treasurydirect.gov
The impact of the Fed can first be seen as interest rates fell from 1.5% to .6% during the initial buying spree. After the initial burst, the Fed put QE on auto-pilot, buying “only” $80B a month in long-term Treasuries. However, because the Treasury was issuing more than $80B a month as depicted by the positive bars starting in June 2020, interest rates started rising.
This trend started to accelerate in November of 2020, as long-term debt issuance was outpacing Fed Buying by around $200B. Things really started to escalate in the first quarter of 2021 as Treasury Debt issuance surpassed Fed buying by $286B in March right as interest rates were crossing above 1.7%.
Then, suddenly, long-term debt issuance started falling in April and was almost even with Fed buying in May. This consequently led to a fall in long-term rates, which are now hovering back around 1.5%. How did this happen just as Biden was pushing through a $1.9 stimulus package? Unlike 2020, when short-term debt issuance was used to plug the gap, Figure 1 above shows that short-term debt issuance was actually turning negative (blue bars).
What gives?
One look at the Treasury Cash Balance sheet in the chart below tells almost the entire story. This was first highlighted by a SchiffGold article published June 16. The chart below shows a massive surge in cash reserves by the treasury last year. Since March of this year, the cash balance has plummeted by over $1T.
Source – Treasurydirect.gov
Inflation Expectations
Why such a massive and sudden drawdown in the cash balance? In truth, there could be lots of reasons, but it does seem extremely sudden. One would think the Treasury, led by Yellen, would be very deliberate and thoughtful about how to use up $1T+ in dry powder. For the past 3 months, the Fed has been shouting from the rooftops that inflation is transitory. At the June FOMC press conference, Powell stood up and explained how long-term inflation expectations remain well-anchored. A proxy for inflation expectations is long-term interest rates.
Had interest rates continued to rise similar to the recent trajectory (climbing from .8% in Nov to 1.7% in March), this would have been a difficult narrative to push. The Fed needs inflation expectations to remain in check or else inflation will be anything but transitory. Thus, the perfect time for the Treasury to pause issuance of long-term debt would be April-June 2021 just as the economy is re-opening and the Fed is forecasting inflation to be at its worst before coming back down.
While this is speculation, it would be a very strategic move from both Powell and Yellen. Regardless of the intention though, the problem is that the Treasury has now spent its large cash balance. It could return to the short-term debt market, but the outstanding balance is still sitting above $4T (see part 1). It needs to be converting that short-term debt to long-term debt while long-term interest rates are still low and the Fed is still buying. But the Fed is simply not buying enough at $80B to convert all that debt!
If inflation persists beyond a few months, then interest rates are going to rise in a hurry as the market demands higher rates. Adding fuel to the fire will be the Treasury debt issuance overwhelming the $80B Fed buying as it did from November to March.
Then what?
Who is absorbing the long-term debt to keep interest rates from returning to the upward trajectory from Aug 2020 – Mar 2021?
International creditors have had little appetite for US Debt lately. The chart below shows the total outstanding debt held by foreign governments. In the past 15 months, while the Treasury has issued over $4T in new debt, the net amount bought by foreign governments is close to zero.
Source – https://ticdata.treasury.gov/Publish/mfh.txt
To zoom into the exact amount of change since the massive debt issuance, see the chart below. In total, foreign creditors have absorbed $120 billion of $6T+ or less than 2% of total issuance!
Source – https://ticdata.treasury.gov/Publish/mfh.txt
How are rates going to stay low if the Fed keeps the treasury buying cap at $80B? The Treasury will have to issue more than $80B in long-term debt to continue funding all the massive spending. If inflation expectations stay low, maybe the market will have enough firepower to ingest some of the new debt, but not all of it. With the Fed planning to begin tapering at the end of the year, someone will need to fill the $80 billion void. This does not even take into account the possibility of shrinking the Fed balance sheet, which should be considered impossible at this point.
The chart of the international holders above brings to mind the image of the Wiley Coyote running off a cliff. With 10-year interest rates hovering near 1.5%, one could argue there is strong demand for long-term Treasury debt. Unfortunately, foreign creditors have turned off their debt purchases. It took decades for them to accumulate ~$7T in Treasury debt. The Fed alone has accumulated more than half that (~$4.5T) over the last decade. The Fed is making the market seem strong, but as shown above, there might be nothing but air if they were to exit the market. With a thumb on the scale, no one is getting an accurate reading of true demand for US long-term debt.
Source – Warner Brothers
What about short-term debt markets?
As highlighted several times, the demand for short-term debt seems to remain very strong. This makes sense as T-Bills mature in less than a year, so these investments are perceived as nearly risk-free. In fact, it could be argued that the recent Treasury Bill issuance hiatus (Figure 1 – blue bars turning negative) could be causing stress in the Reverse Repo market. The chart below shows the current Reverse Repo market. Based on past quarter-end data, it’s very possible that Reverse Repos could exceed $1.5T by this coming Wednesday, June 30, before coming back down.
Source – https://fred.stlouisfed.org/series/RRPONTSYD
Many articles have been written to explain this phenomenon, without providing exact clarity on what’s actually going on. The current understanding seems to be that the banks are awash with cash – so much cash, they are hitting the limits in terms of how much cash they can hold on balance overnight. This is cash that should be invested on behalf of money market funds. But with so much cash in the system, if it were to all be invested in short-term debt instruments, it could drive rates negative. To avoid negative rates, the Fed is lending banks assets on its balance sheet overnight in exchange for cash. It is critical to avoid negative rates to insure money market funds never experience a loss and result in breaking the buck.
Maybe this is a leap too far, but it seems another solution to the Fed reverse repurchase activity could be for the Treasury to issue more short-term debt. So, why has the Treasury been drawing down its cash balance and letting short-term debt mature when there seems to be strong demand in the market? The Treasury must recognize the risk of having too much debt in short-term instruments and is trying to lengthen the duration of its debt outstanding. Unfortunately, this abundance of cash in the repo market is in search of low-risk short-term debt so will not provide demand for long-term debt.
If this is the case, it has created quite the pickle for the Treasury. By issuing too much short-term debt, the Treasury is by default putting pressure on the Fed to not raise short-term interest rates. However, by issuing too much long-term debt, the Treasury is by default putting pressure on the Fed to maintain or even increase quantitative easing. To reiterate, this is why it is imperative the market believes inflation is transitory. The Treasury cannot stop issuing debt, which leaves the Fed unable to raise rates or taper QE without wreaking havoc in the bond market. Additionally, if the Fed has to fight inflation, then it’s not just the Treasury facing its Wiley Coyote moment, but the entire US economy.
Wrapping up
With the economy reopening, the Treasury deployed its cash balance at the most opportune time, unless of course inflation numbers continue to increase (which based on all the data, anecdotal evidence, and liquidity in the repo market seems like a strong possibility). Unfortunately for the Fed, the Treasury will have to begin re-issuing debt again. Will it lean towards short-term debt hoping the Fed keeps interest rates low, or long-term debt hoping the Fed will expand QE?
But Fed may be constrained either way because it has its own problem. Powell must be praying that inflation readings come in low AND job numbers disappoint. If both don’t occur, then tough questions will be asked to justify more stimulus. Yellen and Powell may be best buds, but simple coordination will not be enough. They will need magic and luck to keep the course steady heading into 2H 2021 and 2022.
If the Fed is lucky enough to get low inflation readings out of its rigged CPI, it may provide cover to begin tapering. Rising long-term rates won’t have the same compounding effect on inflation expectations in a “low” inflation environment. Unfortunately, long-term rates will not be tenable over the medium term as the government has to finance more and more debt. As the market this year has indicated, when issuance surpasses Fed buying, rates have gone up. So what happens to rates when the Fed leaves the market entirely? Presumably, they go up a lot. How high will the Fed let rates go before re-entering?
Just because something is inevitable (US Debt spiral) does not make it imminent; however, the next six months of data may shine a bright light on all the irresponsibility over the last 12 years if inflation proves not so transitory. Chances are, the only thing transitory will be “talking about talking about” tapering.
US Debt interactive charts and graphs can always be found on the Exploring Finance dashboard: https://exploringfinance.shinyapps.io/USDebt/
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McMaken: The Fed’s Inflation Is Behind the Supply-Chain Mess
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