The next Fed crisis is already brewing. Unlike 2008, where “subprime mortgages” froze counterparty trading in credit markets when Lehman Brothers went bankrupt, in 2022 it could be the $27 trillion Treasury market alone.
When historians review 2022, many will remember it as a year in which nothing worked. This is very different from what people thought would be the case.
Throughout the year, rising interest rates, the Russian invasion of Ukraine, soaring energy costs, inflation at 40-year highs, and the draining of liquidity from stocks and bonds rocked to the markets. Since 1980, bonds have been the de facto hedge against risk. However, in 2022, bonds suffered the worst drop in over 100 years, with a 60/40 stock and bond portfolio posting a horrible -34.4%
The bonus reduction is the most important. The credit market is “soul” of the economy Today, more than ever, running the economy requires ever-increasing levels of debt, from corporations issuing debt for share buybacks to operations and consumers leveraging themselves to maintain their standard of living. The Government requires the continuous issuance of debt to finance spending programs, since it requires all tax revenues to pay social welfare and interest on the debt.
For a better perspective, it currently requires more than $70 trillion in debt to sustain the economy. Before 1982, the economy was growing faster than the debt.
Debt issuance is not a problem as long as interest rates remain low enough to support consumption and there is a “buyer” for the debt
The lack of a marginal buyer
The problem comes when interest rates rise. Higher rates reduce the number of willing borrowers, and debt buyers resist falling prices. The latter is the most important. As debt buyers evaporate, the ability to issue debt to finance spending becomes increasingly problematic. Such was a point recently made by Treasury Secretary Janet Yellen.
“We are concerned about a loss of adequate liquidity in the [bond] market.”
The problem is that outstanding Treasury debt has expanded by $7 trillion since 2019. Yet at the same time, the major financial institutions that act as “primary distributors” they are unwilling to serve as net buyers. One of the main reasons for this is that, over the last decade, banks and brokerage houses had a willing buyer to whom they could unload Treasury bonds: The Federal reserve.
Today, the Federal Reserve no longer acts as a willing buyer. Consequently, primary dealers are unwilling to buy because no other party wants the bonds. In function, the liquidity of the Treasury market continues to evaporate. Robert Burgess He summed it up nicely:
“The word ‘crisis’ is not hyperbole. Liquidity is rapidly evaporating. Volatility is rising. Once unthinkable, even demand at government debt auctions is becoming a concern. Conditions are so worrisome that Treasury Secretary Janet Yellen took the unusual step Wednesday of expressing concern about a possible collapse in trade, saying after a speech in Washington that her department is “concerned about the loss of adequate liquidity” in the $ market. 23.7 trillion for US government securities. Make no mistake, if the Treasury market seizes up, the global market, economy and financial system will be in much bigger trouble than high inflation.”
It is not the first time this happens. Every time the Federal Reserve previously raised rates, it tried to stop “quantitative easing,” or both, a “crisis event” It occurred. This required an immediate response from the Federal Reserve to provide a “accommodative policy”.
“All of this comes as Bloomberg News reports that the biggest and most powerful buyers of Treasuries, from Japanese pensions and life insurers to foreign governments and US commercial banks, are pulling back at the same time. We need to find a new fringe buyer of Treasuries as central banks and banks in general are exiting scenario left.” -Bloomberg
It’s not a problem until something breaks
As discussed above, although there are “warning signs” of fragility in financial markets, are not enough to force the Federal Reserve to change monetary policy. The Fed pointed this out in the minutes of its recent meetings.
“Several participants noted that, particularly in the current highly uncertain global economic and financial environment, it would be important to gauge the pace of further policy tightening in order to mitigate the risk of significant adverse effects on the economic outlook.”
While the Fed is aware of the risk, history suggests that the “crisis levels” necessary for a change in monetary policy remain in the distance.
Unfortunately, history is littered with monetary policy mistakes where the Federal Reserve got too tight. As the markets rebel against quantitative tightening, the Fed will eventually accept the avalanche of selling. The destruction of the “wealth effect” threatens the functioning of equity and credit markets. As I will discuss in a future article, we are already seeing the first cracks in both the FX and Treasury markets. However, volatility is increasing to levels that were previously “events” It occurred.
As noted in “Inflation will turn into deflation”, The main threat to the Fed remains an economic or credit crisis. The story is clear that the Fed’s current actions are once again lagging behind. Every rate hike brings the Fed closer to the unwanted “event horizon”.
“What should worry the Fed and the Treasury Department the most is the deterioration in demand at US debt auctions. Standard deviation below last year’s average.” Bloomberg News.
When the lagging effect of monetary policy collides with accelerating economic weakness, the Fed will realize its mistake.
A crisis in the Treasury market is likely to be much bigger than the Fed thinks. That’s why, according to to Bloomberg, there are already potential plans for the government to step in and buy back bonds.
“When we warned last week that Treasury buybacks could start to enter the debt management conversation, we didn’t expect them to jump so abruptly into the spotlight. Liquidity strains in September may have sharpened Treasury’s interest in buybacks, but this is not just a knee-jerk response to recent market developments.
If something is breaking in the Treasury market, it’s probably time to buy long-term Treasury stocks and bonds like the next “Put the Federal Reserve or the Treasury” returns.
Publisher’s note: The bullet points in this article were chosen by the editors of Seeking Alpha.