The tricky task Jerome Powell has: taming inflation in the midst of a record deficit.
Good morning I’m Austerity Jones and I am here with C Thomas Printer. C Thomas, what do you have for us today?
C Thomas: Good morning Austerity. One of my favorite stories is the following. Warren Buffet asks a group of people what the most important quality to look for in a spouse is? Is it brains, looks, sense of humor etc? They don’t know. He says low expectations. This is the best answer to a most important question. When we look at our government leaders today, I have very low expectations. That isn’t the best answer or even a good one, but merely sad. Now, there is one individual that I hold out my hope for. I believe that Jay Powell could try and fool us by channeling his inner Paul Volcker, and just as Volcker saved us in the late 70s Powell could be trying to do the same thing today. Now this is quite a stretch, but hear me out. I know that Powell pivoted in 2018 and that he was responsible for all of the Covid spending. What if he knew our economy wasn’t ready for the Volcker style discipline that was needed? What if he knew that if he tried to impose austerity measures that our economy would fail. There have been a lot of smart people that said we could never get to 4% interest rates without something breaking or the economy crashing yet here we are today. This might be why Powell had to wait before he made his play, and it might have been a wise decision. We have a $31 trillion debt that must be repaid and most of that is in short term treasuries that have an interest rate that is rising by the month.
This means that money must be taken out of the financial system through taxation to pay for these government obligations. We had to wait to get rid of LIBOR- no more meetings of crusty old Brits setting interest rate policy. That is a bygone relic as we now have a new program called SOFR. Maybe Congress could fool us by putting an end to raising the debt ceiling. We could say that we will not raise the debt ceiling $1 more and the US govt will have to balance their budget from now on. Forget for a moment trying to pay the debt down since we should focus on one miracle at a time. This $31 trillion will keep rolling over and by that, I mean the US treasury will have to sell new debt in the form of bonds or t- bills to simply maintain our current levels. Let’s say Jay Powell knew all of this and had to keep waiting and telling us inflation was transitory and buying time. Now he is making his move.
Unfortunately, he is taking interest rates up. This means that merely having $31 trillion in debt will be worse next year than this year. The difference between 2% interest and 4% interest on our government debt is $620 billion dollars in comparison to all of our defense spending which is about $700 billion. We are now shifting a defense budget size amount of money from taxpayers to whom you may ask? People or entities that own treasuries is the answer. Pensions, university endowments, insurance companies, foreign governments, and even our own citizens all own treasuries. Now the US treasury is considered the safest blue-chip asset in the world. It is backed by the full faith and credit of the United States. It is used for collateral in all kinds of swaps and derivatives and banking products that I won’t bore you with here.
Let’s say for our example here that a pension program has invested by buying a 10 year US treasury at 4% which is about where they are priced today. This is the same bond that he bought 3 years ago at 2% let’s say for simplicity. Now he likes getting 4% on his money far more than 2% especially for the next 10 years, so what does he do? Let’s say for simple math that the pension holds 50% bonds and 50% stocks. So that means at 2% he would need his stock side of the portfolio to generate 12% returns, why? Pension programs have built in assumptions that 7% (on average depending on the pension) annualized returns are required to ensure that their future recipients are going to receive what they were promised.
Bonds are interesting instruments in that when yields go up the price of the bond goes down. So when I say rates have gone up from 2% to 4% that means the price of the bond has dropped significantly. Our pension fund’s manager can sell that old 2% bond (called off the run) at a big loss and he can replace it with a new bond (on the run) that pays 4%. However, that is how bonds are priced so he really doesn’t gain anything, his loss on the sale of the 2% over 10 years roughly equals what he would make incrementally on having a 4% bond for 10 years. Older off the run bonds are traded less and less as they age which creates liquidity problems. So Mr. or Mrs. pension fund managers are stuck with an old 2% bond and a stock market that isn’t going up this year which means that they are falling behind their 7% benchmark and quickly. So what do they do? They lever up means increase the leverage.
If you want to lift a car, you use a jack which has a handle, and you can use leverage to lift a car. If you have to make 7% in your pension and the stock market is down and your bonds are only making 2% you have to increase your leverage. Why?
If you don’t make your 7% you will get fired. That’s why.
That’s right Austerity. Someone else will claim that they can make 7%, which is rubbish, as all they are going to do is lever up as well, but you don’t want that to happen so you lever up using a variety of financial tools like the car jack- derivatives, futures, options, swaps etc. Now when you use your car jack, you slowly ratchet it up and lift your car, change your tire, and then slowly ratchet it down. Leverage can be useful. Leverage has been useful in the markets as well, it has allowed pension managers to meet or almost meet their numbers as the interest rates have been low and the stock markets have gone up 400% since 2008 in the great financial crisis. The problem with leverage is when it comes out all at once. If you lose your leverage when changing a tire, the car will fall on you and smash your foot or worse and the markets are no different. That’s why the speed of what the Fed is doing raising rates is so concerning. We inflated the money supply during Covid so quickly and by so much that we got an inflation problem very quickly and now Powell is trying to match that speed with his rates of increase in interest rates and quantitative tightening by reducing the Fed’s balance sheet but getting the timing right is going to be tricky at best.
You have heard that the Federal Reserve will keep raising rates until they break something right? Well, one of the things that can break is the liquidity in the treasury markets. Powell tried to raise rates in 2018 and the market fell 20% in December, and he had to pivot. The overnight rates almost broke in September of 2019. The whole system almost imploded in Mar 2020 during Covid. Each time the government had to step in and provide cushion for the leverage. This is exactly what the Bank of England had to do a couple months ago and it was their levered pensions that almost broke their system. Now Jay Powell knows this as he worked and left Bankers Trust because he saw how derivatives can work against you and didn’t like it. He was in charge in 2019 when the overnight markets slipped and almost broke. No one even talked about the overnight markets until this and even now many people don’t know what happened or why fixing it was so important. Now there is an overnight facility to help liquidity in that system. Powell did research while at the Bipartisan Policy Center, a DC think tank, about the dangers of default. This man knows what to look for.
So one of the ideas being floated is to have the US Treasury buy off the run bonds and replace them with new on the run bonds which would provide better liquidity. We have just shown that the price would be the same as it is simply an exchange. However, the retirement and exchange of old bonds isn’t our concern here- it’s the higher interest rates on new debt that is truly worrisome. We are running a $1T deficit which means an additional $60B in debt expense every year at 6%. This is the equivalent of adding a new food stamp program every year. That’s right- all the food stamps in America have to go away if we can’t find another way to pay for this debt, or we can raise taxes, or we can default. Jay Powell knows all of this, and although on our money it reads in God we trust, well now we must trust Jay because I am quite sure that God has said “you want to do this the easy way or the hard way and said all right go ahead.”
Sincerely Yours,
C Thomas Printer
If you want more details on how the Federal Reserve and its bond buying programs work, I recommend Joseph Wang’s book Central Banking 101.
This week’s financial tip
I saved almost $50 bucks this week at the store by using my loyalty card! Did you save this week as Christmas is no excuse, you pay yourself first. Go grab that silver dollar and flip it up in the air and feel the weight of it and realize that money is a store of value. If you must give presents, give cash- it is better value. First of all the receiver gets to go buy what they want and when they go to the store for the after Christmas sales will allow them to get more value for your gift. Trust me, it’s a winner.
On this date in history
137 years ago to be exact, slavery was abolished in the United States. Righting a wrong is better late than never.
Also born on this date
Archduke Franz Ferdinand whose assassination sparked the beginning of World War I and Joseph Stalin who also defeated Hitler from the east and helped end World War II.