Where Will We Get the Cash?
Last week’s turbulence shined a harsh spotlight on the stock
market. Appropriately so, if that’s where your investments are. But in the
hubbub many investors are missing the deeper and far more urgent bond market
issues.
We already knew interest rates were rising. Recent data suggests
they could rise significantly more than many expected just a few weeks ago. If
so, that will be a big problem for bonds, stocks, and many other assets – not
to mention taxpayers who will bear the cost of swelling government debt, consumers
who may face inflation, and everybody who will be hurt by a recession.
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The combination of a falling stock market and rising interest
rates is historically and statistically rare. Normally, when the stock market
goes through a correction, interest rates fall. Looking back through history,
we see that 1987 and 1994, two years I have been writing about in connection
with 2018, were the other unusual years.
I’ve been relatively optimistic on the economy this year, and I
still think the year can end well. But given recent events, the path is more
challenging now – and the odds of a rough 2019 are growing.
Burn Rate
Sudden market moves usually have many contributing factors, but
they still need a trigger. Typically, it’s some new piece of information that
wasn’t already reflected in prices. What did we learn just ahead of the drop on
February 2 and then the bigger one on February 5?
I still think the key factor was the Friday unemployment report,
which showed wage growth of 2.9%. It is been a long time since we’ve approached
3% wage growth. The markets, probably rightly, interpreted this as a sign that
the Fed will turn more hawkish if that trend continues. The Fed’s going into
inflation-fighting mode is not bullish for the market. From a recent
Congressional Budget Office (CBO) statement:
Next, because the tax legislation reduced individual income taxes
for most taxpayers, the Internal Revenue Service released new income tax
withholding tables for employers to use beginning no later than the middle of
February 2018. As a result of those changes, CBO now estimates that, starting
in February, withheld amounts of individual income taxes will be roughly $10
billion to $15 billion per month less than anticipated before the new law was
enacted. Consequently, withheld receipts are expected to be less than the
amounts paid in the comparable period last year. In addition, the government
ran a deficit of $23 billion in December, and it normally runs a deficit in the
second quarter of the fiscal year.
We knew part of this. The tax bill President Trump signed in
December was passed under reconciliation rules that allowed the reduction of
revenue by $1.5 trillion over 10 years. That works out to $12.5 billion per
month, roughly the amount CBO says tax withholding will drop. Economic growth
is supposed to offset this. I think it will to some extent, but not enough and,
more importantly, not soon
enough.
Also on Friday, in a separate report,
the Treasury Department estimated that it will borrow $955 billion in FY 2018.
That estimate is based on input from a group of private banks that advise the
Treasury. If the amount is correct (and it may not be), it will represent an
84% increase over the $519 billion Treasury borrowed for FY 2017.
This huge
increase is clearly not taking us in the right direction, and it’s more than
can be accounted for by lower tax revenues. Nor is it a one-time blip. The same
report forecasts borrowing of $1.083T in FY 2019 and $1.128T in FY 2020.
The budget that has now been passed by the Senate and is likely to
pass the House and be sent to Trump to be signed will add another $300 billion
to the deficit over just the next two years. We are going to exceed $1.2
trillion in average debt for the next three years, and that’s just the
on-balance-sheet deficit.
What’s the problem, you ask?
The answer will get us into some little-examined and perhaps
arcane fiscal policy issues. They are nevertheless important. In short, the budget deficit and the amount of government borrowing (for the
year) are two different things. The official deficit increasingly
understates the problem… and I think markets are starting to realize that.
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Politicians like to talk about managing the federal budget the way
you manage a family budget. This rhetoric makes for good sound bites but
ignores an obvious reality: The federal government isn’t like your family. It
has exponentially greater powers and responsibilities and is a sprawling
behemoth to boot. The same budgetary principles don’t always apply.
For one, you can’t set your home budget and then add additional
expenses without changing your budget parameters. The government can do so, and
it does. These are the so-called “off-budget expenditures” you may have heard
about. They don’t affect the official deficit that is discussed in the press.
They do affect the amount of cash the government needs. Where does it get that
cash? It borrows it by issuing Treasury paper.
Off-budget expenditures pay for a variety of programs: Social
Security, the US Postal Service, and Fannie Mae and Freddie Mac are among the
more familiar ones. But the category also includes things like disaster relief
spending, some military spending, and unfunded liabilities that turn into
actual costs. Federal student loan guarantees sometimes force the government to
disburse cash. That’s an off-budget outlay.
Off-budget outlays have risen in part because they include Social
Security benefits, and the Baby Boomer generation is retiring. But the other
categories mentioned above have grown as well, and they are increasingly
problematic.
The Treasury Department has the unwelcome job of juggling the
government’s cash flows to pay the people and businesses Congress has decided
should be paid. When there isn’t enough tax revenue, Treasury must borrow to
meet the difference. Any unforeseen decrease in tax revenue or increase in
expenses can force it to borrow more. This activity has nothing to do with the
formal “budget” even when we have one, and we currently don’t.
Do you remember a headline mentioning annual trillion-dollar
increases in the US debt during the last eight years of the Obama
administration? I didn’t think so.
The problem has been papered over by off-budget receipts, mainly
Social Security taxes, that give the US Treasury more cash it can disburse. But
eventually the benefits those taxes represent come due. Then outlays go up, but
revenue may not.
We are rapidly reaching that point. Look at this table, which
I found here
and excerpted:
National Debt by Year:
Compared to Nominal GDP and Major Events
You will notice that there are many years during which the US debt
rose by more than $1 trillion. Note that 2015 saw an increase of $1.4 trillion,
while the on-budget deficit that year was “just” $439 billion.
Admittedly, 2015 was an outlier, but lately it hasn’t been much of
one. Look at this chart
of the on-budget deficit for the last 10 years. Comparing to the above table,
you can see that off-budget deficits have been running more than $500 billion
recently. Some years not so much, but the general trend has been from the lower
left to the upper right.
But wait, there’s more.
Since 2008 the Federal Reserve has greatly simplified Treasury’s
cash management task. It has kept short-term rates ultra-low, allowing the
Treasury to borrow tons of cash with minimal financing costs. The Fed also
bought Treasury bonds directly as part of its quantitative easing programs.
Since the Fed sends most of the interest it receives right back to the
Treasury, those bond purchases amounted to almost interest-free financing. The
average interest paid on the US debt has been reduced to less than 2%, largely
because Treasury has loaded up on short-term debt in order to reduce the
interest-rate costs that must be allocated to the budget deficit each year.
So
rather than focusing on long-term debt with the 30-year at an all-time low,
Treasury has been selling short-term bills and notes. That’s good cash
management in the short run and very shortsighted in the long run.
Both those factors are now changing. The Fed is actively raising
short-term interest rates while also reducing its Treasury bond purchases. The
FOMC’s December “dot plot” suggests that rates will rise to 2.25% by the end of
this year and to 2.75% in the longer term. This increase will raise Treasury’s
interest costs considerably. And the interest must itself be financed, so that
requirement will drive borrowing needs yet higher. Do you think the chances are
good that the Treasury will be able to finance its debt at 2% in 2019? Me
neither. And with $20 trillion total debt, even a 0.5% interest rate increase
will have an impact on the overall budget deficit.
On the balance sheet unwind, here again is a chart I shared last
week:
The important point here is that the Federal Reserve balance sheet
reductions are just now getting started. The pace will quicken. In January the
Fed’s Treasury bond assets dropped by $18 billion. The shrinkage will vary by
month, but the combined total Treasury and mortgage bond balance is set to fall
$420 billion this year and another $600 billion in 2019. The number will
continue to fall at that pace until either the balance sheet reaches zero or
the Fed decides to stop.
This path would be fine if the Treasury’s cash needs were likewise
falling. Instead, they are rising. That $1 trillion that the Fed is going to
sell back to the market will cost the Treasury a minimum of 2% and probably
closer to 2.5%. That increases the deficit by $20–$25 billion a year.
So let’s add it up. The federal deficit will be north of $1.1
trillion. Let’s assume the off-budget deficit actually drops to $400 billion
and that the Federal Reserve is going to want to sell $460 billion into the
market. (Note: some of that will be mortgages, and the rest will be US bonds
and bills.)
Simple arithmetic suggests that we will need to find about $2
trillion in additional funding to buy government debt in 2018. And candidly,
that may be an optimistic projection.
Which brings us to this letter’s titular question: Where will we
get the cash?
In theory, it should not be a problem for the US government to
borrow all the cash it needs. Occasional political antics aside, we are the
world’s best credit risk. No one worries that they won’t get their T-bond
principal back. The entire global financial system depends on that rock-solid
guarantee.
So, the question is less whether Treasury can repay than whether
potential borrowers are healthy enough to supply our needs or might see better
alternatives. This question is important because Treasury is losing the Federal
Reserve as a primary funding source. Who can take its place? There are several
candidates. Unfortunately, each has barriers that may reduce their buying
interest.
American savers and investors are prospects if they have money to
lend.
Unfortunately, the number who do is not growing. It may grow if
unemployment stays low and wage growth accelerates, but the Baby Boomers are
transitioning from savings mode to spending mode, so they won’t help much.
US pension plans and other institutions that need to fund future
obligations are natural Treasury buyers, too. Higher rates might entice back
some buyers who have moved into corporate or other long-term bonds in the last
decade. Then again, high enough rates will entice anyone back, but those higher
rates come with a cost.
Specifically, each 1% higher is $10 million per
trillion dollars of debt issued. On our $22 trillion in total US debt (by the
end of the year, give or take a few billion), that will eventually be about
$220 billion in interest as rates go up and the debt has to be rolled over.
That’s interest per year!
That means we are spending approximately 15% of our revenue and
12% of actual expenditures just on interest.
There is also the issue of state and local pension funds, many of
which have vast future obligations that are poorly funded and will likely
remain so, given these entities’ precarious financial condition. They should
probably be buying more Treasury paper, but it’s not clear that they can.
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Other natural buyers are overseas. You hear a lot about China’s
owning so much of our government debt. It’s true, but to some degree they have
little choice. So long as the US runs a trade deficit with China and we insist
on paying for our imports with dollars, China will probably continue to use
those dollars to buy dollar assets with that export revenue. It can happen
indirectly: Maybe China buys raw materials from Australia with the dollars, and
then the Australians buy dollar assets. But in any case, the amounts are so
vast that the Chinese gravitate toward the most liquid dollar asset –Treasury
bonds.
China would like to convince its trade partners to deal in
renminbi, and the partners are very slowly coming around. This is happening
especially through China’s gigantic One Belt, One Road infrastructure initiative.
The Asian and African nations where China is building ports, railroads, and
other facilities are being “encouraged” to accept renminbi in payment and then
use the currency to buy Chinese goods. But the simple fact of the matter is
that a lot of the projects for One Belt, One Road require the spending of
actual dollars.
That Chinese process is unfolding slowly. I don’t worry about
China’s suddenly deciding to boycott US bonds. The Chinese don’t presently have
that choice. However, they firmly intend to reduce their dollar dependence
wherever possible. I don’t see them volunteering to lend us significantly more
cash than they do now. And indeed, they have been reducing their dollar
purchases – significantly.
OPEC is another once-reliable lender that is becoming less so. The
reason isn’t complicated. Growing US shale production reduces our need to buy
oil from OPEC countries, in the Middle East and elsewhere. We are buying 7
million barrels per day of oil less from outside the US than we used to. If OPEC
countries ship us less oil and gas, we ship them fewer dollars, and they lose
capacity to buy our debt, even if they want to.
In fact, federal debt held by foreign investors rose from about $1
trillion in 2001 to around $6 trillion in 2013, but it has more or less gone
sideways since that point. China and Japan are no longer buying large amounts
of US debt. They’re not selling it, either.
Look at it this way. I have a few fairly wealthy friends who are
aggressive gold bugs. But when I ask them privately whether they are adding
much to the actual physical gold they own, they say, “Not so much.” Even though
they are firmly convinced that gold is eventually going to $10–15,000, their
appetite to increase their gold holdings seems to be sated.
In the same way, China and Japan and many other foreign countries
seem to be saying, “We have enough US bonds; let’s see if we can find some
other way to spend our money.”
Please note that Japan, Australia, and Europe all have initiatives
to build infrastructure and to be part of the growth that is going to be
happening along with One Belt, One Road. China is entirely comfortable with
those moves, since that is money they don’t have to spend – all they really
need is the transportation infrastructure to move their products back and
forth. They are perfectly willing to let Europe and Australia help build out
Africa and Southern Asia.
And while the matter doesn’t get much play, and the Trump White
House doesn’t seem to notice, the renminbi is actually quite strong. Chinese
consumers are in the best shape they have been in for a long time, and they are
using the strength of their currency to import goods, which typically have to
be bought in dollars.
Further, many of the large state-owned enterprises have
dollar-denominated debt that is essentially guaranteed by the Chinese
government. Some of those dollars are going to come back to pay lenders,
wherever they may be from.
You can go to this
link to see how much each government around the world has actually invested
in US Treasury securities. Interestingly, Ireland and the Cayman Islands are in
third and fourth place behind China and Japan. At one point this past year,
China actually had a little less in Treasury securities than Japan did, but
they are both above $1 trillion total. The next four countries combined are up
to $1 trillion+ total. And so on. You will also notice that many of the 10
largest holders are associated with major banking centers. And while their
appetite is still rising, it is not growing by much.
Foreign buyers may represent another $400 billion available this
year to purchase US Treasury securities. That still means we have to find at
least $1.5 trillion from US sources. The smart money suggests that interest
rates are going to have to go up in order to attract those buyers. That is one
of the reasons we are seeing the very unusual circumstance of interest rates
rising at the same time the stock market is falling out of bed.
Sidebar: The US 10-year yield is at 2.86% as I write. That is up
from 2.05% last July, but is still lower than it was little over four years
ago, when it hit 3%. Then, 3% 10-year yields didn’t stop the bull market.
As you can see, our lender search won’t necessarily be quick or
easy. There is one sure way to scare up lenders … but it has a few drawbacks.
The US financial industry is extremely adept at evaluating credit
risk for individual borrowers – or at least it thinks it is. Most folks can get
a loan if they want one, but your interest rate will reflect your
creditworthiness.
Similarly, Treasury can borrow all it needs by paying higher
rates. That’s not the preferred outcome, but it is probably what will happen.
We are already seeing rates trend upward as the benchmark 10-year climbs toward
3% from near 2% just 8 months ago. This rise also reflects inflation
expectations, but the growing supply of Treasury debt is still the key.
Last week may be just a hint of what is coming. Credit markets are
nothing more than borrowers competing against each other for lenders. The
Treasury competes with investment-grade corporates, who compete with high-yield
issuers. Then you have municipal bond issuers and many smaller debtors. They
all need cash, but there is only so much to go around.
Rising Treasury issuance will force other borrowers to pay higher
rates, which will in turn make Treasuries buyers demand higher rates. The
process feeds on itself. Borrowers eventually find debt service taking a bigger
bite out of their income. This burden leaves them less to spend on other goods
and services.
Meanwhile, as time passes, borrowers who locked in lower rates
during the QE years will need to refinance and will find they must pay sharply
higher rates. Some won’t be able to do so and will go out of business, laying
off workers and leaving their own lenders holding losses. This process will be
extreme for issuers of high-yield bonds. As noted last week, there is now a
drastically increasing amount of high-yield bond debt that has to be rolled
over every year.
That process eventually adds up to a recession, which makes
government spending rise even more as people lose jobs. How far away are we
from that point? I still don’t expect a recession this year, but the risks will
rise as we get into 2019. From there, the picture worsens quickly.
I don’t want to leave you depressed, so I’ll stop here. None of
this is inevitable, but neither is it unlikely. Now is the time to get ready.
In three weeks Shane and I will be going to Sonoma, where I’ll
speak at my Peak Capital friends’ annual client conference. Then we’ll come
back to Dallas, where I will speak at the S&P
Financial Advisors Forum in downtown Dallas on Tuesday, February 27. If you
are an investment advisor, sign up and let’s try to make sure we get to chat. I
always like to talk to my readers.
After that, I’ll continue preparations for the Strategic
Investment Conference. This is really going to be the best conference we
have ever done, and you don’t want to miss it. We have been holding
teleconferences with the various speakers on what they’re going to be
presenting and how we’ll work the moderating and Q&A panels, and I’m
adjusting the lineup a little to make the ideas flow better.
If the markets have been a little confusing the last week or so,
there is no place better than the SIC to get a handle on what’s coming. I have
some of the best economists and market strategists flying in from all over the
world. There will be a special emphasis this year on looking at the social and
technological changes that are coming in the next 10 years.
Our Thursday night at the conference, the dinner presentation will
feature Democratic pollster Pat Caddell, who saw the fragmentation of society
that led to Trump before anybody else did; Neil Howe, who understands the
Millennial generation better than anyone else; Steve Moore; and myself,
discussing what we all see as the coming fragmentation of society. And I
guarantee you, it will have significant meaning for your investment portfolios.
It is time to position yourself for a world that is going to be transforming.
And we have so much more at SIC this year. We have just finalized
the last couple of speakers, who will address the recent volatility. I always
try to leave a spot or two open to cover the questions that are currently most
on the minds of attendees.
As I’ve said before, conferences are my artform. You don’t simply
gather a bunch of speakers. You find the right speakers and put them in the
right order in order to build on the information presented from the very
beginning to the very end.
You won’t want to miss the presentations by Niall Ferguson and
David McWilliams, nor their discussion/debate right after. I’m looking for a
joke that begins something like, “A Scotsman and an Irishman walk into a bar
and sit down next to an American.”
And let me close with something from the Ministry of Silly
Indicators (located down the hall from the Ministry of Silly Walks). A friend
(whom I cannot name) began to muse about whether the world would feel better on
Monday morning after the Winter Olympics’ opening ceremony. He went back and
looked at the last four Winter Olympics. Going into each of them, the market
was in either a downturn or a serious correction. And on every occasion the
market turned back around on Monday and went on to make new highs. He did admit
that this was a ridiculous indicator, but he thought it was amusing.
And with that brief bit of levity, it is time to hit the send
button. Let me wish you a great week! And stop procrastinating! Sign up for the
SIC and see me in San Diego in a month.
Your wondering who is going to buy $2 trillion worth of Treasury
securities analyst,
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