Treasury Market Is U.S. Fed’s Next Crisis
The Fed’s next crisis is already brewing. Unlike 2008, where froze counter-party trading in the credit markets as Lehman Brothers failed, in 2022, it might just be the $27 trillion Treasury market.
When historians review 2022, many will remember it as a year when nothing worked. Such is far different than what people thought would be the case.
Throughout the year, surging interest rates, the Russian invasion of Ukraine, soaring energy costs, inflation running at the highest levels in 40 years, and the extraction of liquidity from stocks and bonds whipsawed markets violently. Since 1980, bonds have been the defacto hedge against risk. However, in 2022, bonds have suffered the worst drawdown in over 100 years, with a 60/40 stock and bond portfolio returning a horrifying -34.4%
60/40-Worst-On-Record Annual Returns
The drawdown in bonds is the most important. The credit market is the of the economy. Today, more than ever, the functioning of the economy requires ever-increasing levels of debt. From corporations issuing debt for stock buybacks to operations to consumers leveraging up to sustain their standard of living. The Government requires continuing debt issuance to fund spending programs as it requires the entirety of tax revenue to pay for social welfare and interest on the debt.
Total System Leverage VS GDP
For a better perspective, it currently requires more than $70 trillion in debt to sustain the economy. Before 1982, the economy grew faster than the debt.
Dollars Of Debt In Excess Of GDP
Debt issuance is not a problem as long as interest rates remain low enough to sustain consumption and there is a for the debt.
A Lack Of A Marginal Buyer
The problem comes when interest rates rise. Higher rates reduce the number of willing borrowers, and debt buyers balk at falling prices. The latter is the most important. When debt buyers evaporate, the ability to issue debt to fund spending becomes increasingly problematic. Such was a point made by Treasury Secretary Janet Yellen recently.
The problem is that outstanding Treasury debt has expanded by $7 trillion since 2019. However, at the same time, the major financial institutions that act as the are unwilling to serve as the net buyers. One of the primary reasons for this is that for the past decade, the banks and brokerages had a willing buyer to which they could offload Treasuries: The Federal Reserve.
Fed Balance Sheet vs SP500
Today, the Federal Reserve is no longer acting as a willing buyer. Consequently, the primary dealers are unwilling to buy because no other party wants the bonds. As a function, the liquidity of the Treasury market continues to evaporate. Robert Burgess summed it up nicely:
Such isn’t the first time this has happened. Each time the Federal Reserve previously hiked rates, tried to stop or both, a occurred. Such required an immediate response by the Federal Reserve to provide an
Fed Balance Sheet SP500 Crisis Events
It’s Not A Problem Until Something Breaks
As discussed previously, while there are actual of fragility in the financial markets, they are not enough to force the Federal Reserve to change monetary policy. The Fed noted as much in its recent meeting minutes.
While the Fed is aware of the risk, history suggests the necessary for a monetary policy change remain in the distance.
Fed Metrics For Monetary Policy Change
Unfortunately, history is riddled with monetary policy mistakes where the Federal Reserve over-tightened. As the markets rebel against quantitative tightening, the Fed will eventually acquiesce to the selling deluge. The destruction of the threatens the functioning of both equity and credit markets. As I will address in an upcoming article, we already see the early cracks in both the currency and Treasury bond markets. However, volatility is rising to levels where previous occurred.
MOVE Index vs VIX
As noted previously the Fed’s primary threat remains an economic or credit crisis. History is clear that the Fed’s current actions are once again behind the curve. Each rate hike puts the Fed closer to the unwanted
When the lag effect of monetary policy collides with accelerating economic weakness, the Fed will realize its mistake.
A crisis in the Treasury market is likely much greater than the Fed realizes. That is why, according to Bloomberg, there are already potential plans for the Government to step in and buy back bonds.
If something is breaking in the Treasury market, it will likely be time to buy both stocks and long-dated Treasuries as the next returns.
