March 2018 – Monthly Commentary
March has followed the pattern of the previous two months, with heightened equity market volatility creating worry for anxious investors. Despite that worry, the bond market has been a bastion of calmness with the 30-year bond trading in a relatively benign range of 3.22% to 3.00%. Given the continued strength of the U.S. economy, we had expected the bond to come under price pressure pushing the yield closer to 3.5%. That price action has been befuddling, especially given the steadily deteriorating budget deficit. On April ninth, the Congressional Budget Office announced that the deficit would likely hit $1 trillion dollars in 2020, two years sooner than earlier forecast. Investors didn’t blink an eye, which really is no surprise given the complacency that has swept over the public with regard to the U.S.’s profligate spending. The reaction was much the same last month when Republicans pushed through the $1.3 trillion spending bill.
American’s seem to have come to the conclusion that the Fed has and will continue to ensure prosperity for all and the idea of fiscal responsibility has become nothing more than an old fashioned notion. However, we got a glimpse of the future last month when the Treasury Department flooded the market with Treasury Bills. With the risk of a government shutdown earlier this year, Treasury reduced bill issuance in an attempt to stay under the borrowing cap. Because of the prospect of a shortage of T-bills, the yield to maturity in the secondary market plunged below the low end of the Fed Funds range. As a result, the Federal Reserve’s reverse repo program, which is available to select institutional clients and a de facto loan to the U.S. Government, skyrocketed to nearly $500 billion dollars. When a shutdown was averted and the debt cap lifted, Treasury issued nearly $300 billion in additional T-Bills, a 38% increase over the amount issued in February. As a result, T-Bill yields rose sharply and traded above the upper bonds of the Fed Fund range as investors sought to digest the additional supply.
With the increase behind us, T-Bills maturing in early June have fallen in yield by 15 basis points despite the rate hike in March and the expectation of another rate hike in June. The open interest in the reverse repo program also plunged from $500 billion at the peak to $4 Billion at the time of this writing, a nearly 100% plunge in open interest! The message here is that large moves in supply and demand will move the market, despite the Fed’s manipulation. It just so happened that with the freeze in the Bill market there was an alternative investment. We wonder who’s going to be the alternative source of buying when the Treasury is issuing a trillion dollars of additional debt year after year.
There are those who believe that should interest rates rise meaningfully in the face of supply, the Federal Reserve would restart their bond buying program to absorb the additional supply. While that may be sustainable in the near term, it’s a deeply flawed solution longer term for a number of reasons. First one trillion dollars is approximately 5% of GDP and as interest rates rise the compounding effect is going to cause the debt load to rise at an unsustainable pace. Secondly, as rates rise, the value of their existing portfolio is going to fall in value and that is likely to come under congressional scrutiny. Under the current spending regime both of those outcomes have a material probability of coming to pass. The fiscal irresponsibility of the U.S. Government resembles an individual getting caught up in the vicious circle of credit card debt. The debt is sustainable in the beginning but as spending exceeds income, it ultimately overwhelms the borrower.
In the history of money there have been numerous instances of countries pursing such a policy and in the vast majority of cases, the country was forced to either default on their debt, devalue their currency, or both. One has to wonder what will be the outcome for the U.S. dollar. It currently enjoys the status of being the world’s reserve currency and it’s bonds the store of wealth for many nations. That is unlikely to change overnight, but there’s a very good chance that it will erode. The big question is to what extent?