May 7, 2024
The yield on the 10-year US Treasury note declined 17 basis points to 4.51%. This was triggered by the US Fed declaring it would reduce the pace of quantitative tightening, implying less selling pressure on term bonds. Was this Powell giving in to pressure to reduce interest rates, without appearing to do so? And if so, was the sharp rally in the yen justified?
Let's take these two issues in turn. First, yield curve control, or better described as a policy of suppressing bond yields along the curve. The reason for doing this is to make government funding cheaper, and to persuade pension funds and insurance companies that the Fed has interest rates under its control, making the purchase of long Treasuries less of a price risk.
The Fed definitely has an incentive to do this today. Government funding is soaring out of control, and there is increasing doubt in foreign investors' minds that the US Government is already in a debt trap. Janet Yellen's and her officials' visits to China will have dispelled any doubts that this is the case. However, there is little evidence yet that domestic US institutions are of the same opinion as foreign investors, and it is crucial that they be reassured. For the Fed to continue to roll off Treasury debt without reinvesting the proceeds may be responsible from a monetary viewpoint, but simply adds to the funding problem.
Hence, the evidence that Powell is under pressure from the US Treasury to cease tapering US Treasuries.
Powell must be hoping that he can keep interest rates and bond yields at current levels, not only for fear of upsetting the Treasury, but also because of the malinvestments in the private sector. Apart from a blip in 2017-2019 when the Fed funds rate briefly rose to 2.5%, basically it has been almost zero from November 2008 to March 2022. That's almost fourteen years of supporting zombie corporations and unjustifiable debt leverage in both financial models and bank balance sheets. A rise in interest rates from here is bound to crash the private sector, stocks, other financial assets, and property values as the errors in interest rate management come home to roost. And backstopping all this will be the Fed and the US Treasury.
But the most powerful commercial banker in the world warned in a letter to his shareholders that US interest rates could rise to 8% or even higher. Jamie Dimon is firmly in my camp on this issue. He understands what I do: and that is as banks de-risk their balance sheets, the price of credit rises. In other words, from here it will be markets which control interest rates, and the Fed will have to go along with it.
The flight to quality is disastrous for the overleveraged, stocks, and zombie corporations. The beneficiary short-term will be the US Treasury which can continue to sell T-bills. But this is kicking the can down the road: the US Treasury is reducing its debt maturity profile and in the next few years will find it is taking near-cash out of the market to spend unproductively. The inflationary consequences of this funding becomes more immediate because the involvement of long-term savings (pensions, insurance companies, foreign investors) is diminished. This kicked can cannot travel far.
Part of the inflationary fun comes from the carry trade, which is where I bring in Japan. No doubt the sharp rally in the yen from 158 to 152 and change this week was instigated by carry traders who having shorted the yen sought to cover the risk. But the fact remains that 3-month yen can be had for 0.5% or less, and 3-month T-bills pay 5.39%. Unless the BOJ raises rates, this carry-trade will continue and even accelerate to meet the USG's soaring demand for credit.
China, Russia, and their BRICS+ cohort can see this, as do the world's neutrals. They are not going to throw good credit after bad. They don't want to be blamed for triggering an existential dollar crisis, but there's no way they will be persuaded to rescue America and her dollar. The only people who don't see this are domestic American investors and their opposite numbers in Europe, Britain, and Japan.
Reprinted with permission from MacleodFinance Substack.