If Inflation is Raging, Why Are Interest Rates so Low?
And Why Rates Will Soon go Much, Much Higher
In my recent blogpost "Ain't Nothing but a Party" I made the case that the combination of immense fiscal stimulus and Fed money printing would spawn inflation that is much worse than the consensus now expects. Recent data – notably the June CPI, which was 4.7% above its pre-covid levels - seem to confirm my analysis.
Considering this spike in inflation, it is puzzling that the yields of intermediate and long term Treasury debt recently touched their lows for the year. From April 1 to July 19, the yield on ten year Treasuries dropped from 1.7% to 1.2%. That just doesn’t make sense. If serious inflation is an imminent threat, shouldn’t interest rates be moving higher, not lower? What could account for this anomaly? Is it possible that the market has bought into Fed Chairman Powell’s promise that inflation will prove “transitory” and is thus “looking through” inflation signals to more stable prices down the road?
Perhaps, but I think that there is something more fundamental going on. That something is rather mundane, but critically important. In a nutshell, actions by the Treasury and the Fed have created a sharp, albeit transitory, imbalance between the demand for and supply of Treasury debt.
Following is my hypothesis. It all looks a bit complicated, but is really quite simple. It’s just a matter of shifting cash between accounts. Except the Fed can create its own cash:
1. In 2020, US Treasury borrowing was immense, with total national debt increasing $4.5 Trillion, or 19%, to $27.7T. Link: Total Federal Debt
2. Our dedicated public servants evidently were not up to the task of spending this entire bundle. At year end 2020, the Treasury still had $1.6T in cash on deposit in its account with the Federal Reserve. Over the past 20 or so years, the Treasury account has typically ranged between $100B and $400B. Link: Treasury Account at Fed.
3. Over the first six months of 2021, the Treasury has spent down its Fed account by about $1T to $600 B. These are dollars that the Treasury ordinarily would have had to borrow. Thus, thanks to its cash position on Jan 1, the Treasury borrowed $1T less than it normally would have had to.
4. Total Federal debt increased by $400 B from Jan 1 to Mar 31. Unfortunately, this number is only issued quarterly, but let’s assume that the six month total was $800B.
5. The Fed balance sheet increased by ~$850 B in the first six months of 2021. (Some of this was mortgage backs.) Link: Federal Reserve Total Assets
If this is so, then the Fed in 2021 has bought effectively ALL incremental Treasury borrowing. There was no net buying by private investors. But there are certain players such as pension funds and insurance companies who must buy bonds. Moreover, US rates are still much higher than in Europe and Japan, so presumably there is a consistent flow of foreign demand. Clearly, the Fed’s activities are “crowding out” these buyers, driving rates lower.
But what happens next?
There are several pieces to this puzzle.
1. Presumably the Treasury is about done drawing down its Fed account. If so, it soon will need to issue debt to finance any future budget deficits.
2. We don’t know what Treasury borrowing requirements will be over the next 12 months. However, in January, the CBO forecast the fiscal budget deficit to be $3.0T in 2021 and $1.2T in 2023. Given recent legislative noises from Democrats, I see no reason to think this number will be lower than projected. So let’s go with $1.5T over the next six months. Link: CBO Projection
3. Even if the Fed continues buying $120B a month, the private markets will need to absorb ~$800 B in the second half of 2021, versus zero in the first half.
4. IF THE FED ELECTS TO CEASE ITS PURCHASES (TAPERS), THE PRIVATE MARKET WILL NEED TO ABSORB $1.5 TRILLION IN TREASURY DEBT OVER THE NEXT SIX MONTHS VERSUS ZERO IN THE FIRST SIX MONTHS.
5. I think this increase in supply is likely to drive interest rates higher.
In case you need more evidence that Fed policy is completely fakakta, consider this chart:
Link: Fed Reverse Repos
What’s going on here is a bit technical, but the concept is straightforward. Sometimes a bank will have excess reserves (consider it excess cash). When it does, it will lend its reserves overnight to another bank that needs reserves. It makes a bit of money. But when, as today, the banking system overall has too much cash, there is no one who needs to borrow the funds. So the return on the banks’ excess deposits will be zero, and at the extremes, can be negative.
The Fed desperately wants to prevent rates from going negative. But it has injected so much liquidity into the banking system by buying bonds that banks have nowhere to invest their funds. Armed with “reverse repos”, the Fed steps in as “buyer of last resort” to mop up the excess cash and provide banks at least a marginally positive return.
Yes, you are entirely correct. The Fed is printing money by buying bonds at the long end of the curve and shredding it with operations at the short end. You can’t make this stuff up.
(1) Many of these ideas are actually my own, but I want to acknowledge my debt to Lyn Alden and John M. Mason both of whom are contributors to “Seeking Alpha.” I strongly recommend their analyses on monetary matters.
https://www.lynalden.com/july-2021-/
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