Once again, The European Conservative is right on the money.
I have been vocal about my concerns about a troubling trend in the U.S. debt market. There is more evidence that those concerns have merit.
On February 29th I repeated my warning from February 8th that, according to a trend of two independent variables, investors are slowly losing interest in Treasury securities. The same day that I repeated my warning, EUbusiness.com reported on two related variables that corroborate my concerns.
The first of those variables was the expectations that analysts and investors have of interest-rate cuts by the Federal Reserve. Those expectations have recently weakened, as EUbusiness.com explains:
Markets were expecting 150 basis points of cuts by the US Federal Reserve but that has been trimmed to just 75 points over recent months.
This means that there is underlying upward pressure on U.S. rates—and that is precisely the pressure I have been warning about.
Related to the change of expectations regarding interest rates is a trend in the exchange rate of euros vs. dollars. As EUbusiness.com reports, the euro’s recent rise against the dollar has come to an end, which is symptomatic of the change in expectations regarding U.S. interest rates.
When investors expect a decline in U.S. interest rates, they sell off dollars and buy, e.g., euros instead, for the purpose of investing in euro-denominated markets. When they expect less of a drop in U.S. interest rates, they want to keep relatively more of their money in dollar-denominated assets. As a result, the dollar does not weaken as much vs. the euro.
This is exactly the way the key variables are moving. In fact, the yields on U.S. Treasury securities are actually rising. So far, this increase has not caused a major boost for the dollar, but as EUbusiness points out, there has been a “slight rebound” in it vs. the euro.
To make a long story short, the EUbusiness lends credence to my warnings about weakening investor interest in U.S. debt. The fact that investors are now planning for less of an interest rate cut by the Federal Reserve reinforces the troubling trend I have been pointing to. If the slow decline in investor enthusiasm over U.S. debt continues, there will come a point where the Federal Reserve—in direct response to investor sentiments—will have to cancel planned rate cuts.
If this does not help—in other words, if investors force interest rates even higher by continuing to reduce the amount of money they offer per dollar of debt in the U.S. Treasury auctions—then the Fed will be forced to raise interest rates instead.
We are far from that point, and I find it unlikely that we will get there at any point this year. The most likely scenario right now is that the Federal Reserve keeps its federal funds rate unchanged for the time being and makes its first cut in June. Despite the recent changes in the debt and currency markets, the Fed is widely expected to cut its federal funds no later than June.
At the same time, the ‘secondary’ trend is now moving in the opposite direction. In other words, if we look a little bit down the road and see which way the market could go if it shifts course, it will not be toward faster and deeper rate cuts.
It will be toward an upward turn of rates during 2024.
We need to be absolutely clear about what this trend shift would mean. This is not a technical event that concerns just market insiders. It is a matter for every American family and business owner to pay attention to.
At the risk of beating a dead horse, let me make clear that a market shift in this direction would be the direct result of the ongoing erosion of investor faith in U.S. debt. This would be bad for the federal government as it tries to borrow an average of $188 billion in new debt per month, while also refinancing its behemoth of $34.4 trillion of existing debt.
Although a full-scale debt crisis is still unlikely, the markets continue to nudge the U.S. economy closer to one. Every time there is a new expression of concern over the federal debt, and the markets rebound from it, we don’t quite return to ‘normalcy’ again. We slowly move deeper into the uncertain waters between economic stability and economic chaos. The current situation in the debt and currency markets indicates that we are once again probing the preamble of a debt crisis.
For this very reason, it is essential that we explore what such a crisis would look like. It is an improbable but absolutely not impossible scenario. With each day that the current trend of eroding investor confidence continues, the debt-crisis scenario becomes a little bit less improbable.
There comes a point where rising interest rates would shock the U.S. economy into a recession, but unlike every recession since the 1960s, Congress would be unable to stimulate the economy with deficit-driven spending.
When souring investor sentiments make it impossible for the Fed to cut interest rates, there will be a significant exodus of money from the U.S. debt market. It will not happen in the form of a massive sell-off, but instead show up as a drought at the Treasury auctions: a lot less money will be put forward to buy newly issued securities.
In response, the Treasury will have to radically raise the yields. As interest rates rise, Congress is put under acute pressure to do something radical, and rapid, about its big budget deficit. To get an idea of just how significant higher interest rates are for the fiscal cost of the debt:
- Today, the average interest rate on the U.S. government’s outstanding debt of $34.4 trillion is 3.12%;
- A year and a half ago, that rate was 1.87% (for a smaller debt, but that is irrelevant here);
- If the lower rate had applied to today’s debt, the annual fiscal cost of the debt would have been 36% lower than it is today.
That would have saved the U.S. Treasury just over $383 billion on an annual basis.
But just as lower interest rates would save the government money, higher rates increase the cost to taxpayers. Suppose the Treasury continues to borrow at its current rate of $188 billion per month. Suppose also that investors, in an expression of continuously eroding confidence in Treasury securities, reduce their so-called tender offers (money they are willing to spend on buying U.S. debt at auctions) at an accelerating rate consistent with what we have seen since early January.
If this is the scenario going forward, we will hit a critical point for investor confidence in early June. That is when the tender offers at Treasury auctions will fall below $2 per $1 of debt that the Treasury wants to sell.
Although the Treasury would still be able to sell all the debt it needs to sell, the cost of doing so would be very high. Come early June, under this scenario, interest rates in the open market for U.S. debt would reach 6%—with a trend to reach 7% by Independence Day.
At this point, there will be no summer leave for Congress. They will be forced to stay in session to come up with a panic-driven response to the emerging debt crisis. That response can only consist of combined spending cuts and tax increases, i.e., austerity measures; the overarching goal is to reduce the budget deficit upfront, regardless of what the consequences are for the economy as a whole.
The execution of the austerity package will have a depressing effect on the economy. At that point, a regular recession will escalate into a bona fide economic crisis.
What happens after that, politically and economically, is not worth speculating over, at least not at this point. The main problem today is to make Congress take seriously what is currently happening in the market for U.S. debt.
