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TLDR – "too long; didn’t read." We recognize our posts can be lengthy and challenging to digest, so here’s our executive summary:
- The Federal Reserve has little influence on inflation, particularly while fiscal policy continues to fuel trend inflation.
- The Fed's excessively restrictive policy prescription continues to be reactive rather than proactive, as it is making forward-looking policy with backward-looking data.
- Meanwhile, all other major central banks quickly recognized that their sovereign bond markets and currencies could not withstand coordinated global tightening without an artificial buyer (themselves).
- We believe the Federal Reserve is not far behind and will be forced to be the buyer of last resort in the U.S. Treasury market, i.e., print money into an already inflationary environment.
- Until that time comes, the global liquidity crunch is likely to worsen. The eye of the storm, Hurricane Powell, approaches.
- On the other side may lie an unexpectedly strong rally in equities, precious metals, commodities, and all things physically constrained (👋🏼 Bitcoin), further igniting inflation.
- This is the popping of the sovereign debt bubble through financial repression – the transfer of wealth from savers to debtors and the debasement of fiat currencies.
- Prepare for a prolonged period of structural inflation (4-6%) with government-subsidized interest rates (2-3%). This macro environment continues to favor real assets and questions the role of fixed income allocations, particularly government bonds, in conventional asset allocations.
Let’s check in on a few of our favorite (and interconnected) topics: monetary and fiscal policy and the bursting sovereign debt bubble.
Policymakers at Odds 🔎🔍
Powell and his Federal Reserve are busy using a garden house to put out a raging fire while the Biden administration pours gasoline from above.
Historically, when fiscal policy remains loose and monetary policy attempts to tighten financial conditions, the desired reduction in inflation has not come to fruition. In our last post, we discussed the differences in circumstances that faced Fed Chair Paul Volcker when he raised rates and successfully quelled inflation. Most media pundits still think this is Jerome Powell’s “Volcker” moment, and rumors inside the Fed are that he believes it too. This narrative conveniently forgets the experience of Fed Chair Arthur Burns from 1970 to 1978.
From 1972 to 1974, Burns raised the Federal Funds Rate from 3% to 13% and was “ahead of the curve” as inflation trailed the Fed Funds rate. Then recession set in, and Burns cut interest rates as every Fed chair had done before him. Yet, inflation persisted and eventually worsened, which is why the history books remember Volcker instead. Paul Volcker’s Fed is lionized for maintaining aggressively high interest rates throughout the recession to stamp out inflation. Economic dogma stipulates that Volcker’s resolve – “higher for longer” – successfully quelled inflation, but what if it was a different set of factors entirely?
Interest rates alone don’t inform whether policy is expansive or restrictive since the relationship between the price of credit (rates) and the supply and demand for money is ambiguous. As we will learn from Arthur Burns, this is especially the case if an external force like the government meddles in the free markets. Following his stint at the Federal Reserve, Arthur Burns gave a speech entitled “The Anguish of Central Banking”. He reflects on the propensity of the elected government during his tenure to spend, the structural inflation it generated, and how his central bank was primarily helpless to the political whims of the time. We share excerpts below; with some imagination, it’s not difficult to imagine them written today.
“In the innocence of the day, many Americans came to believe that all of the new or newly discovered ills of society should be addressed promptly by the federal government. And in the innocence of the day, the administration in office attempted to respond to the growing demands for social and economic reform while waging war in Vietnam on a rising scale…... When the government undertook in the mid-1960s to address such ‘unfinished tasks’ as reducing frictional unemployment, eliminating poverty, widening the benefits of prosperity, and improving the quality of life, it awakened new ranges of expectation and demand….Their cumulative effect, however, was to impart a strong inflationary bias to the American economy.” (Arthur Burns, 1979) 
In other words – populism is inflationary. Against this backdrop, similar fiscal actions of the current administration driven by the modern political environment continue to support structural inflation undermining the effectiveness of the Federal Reserve’s monetary tightening. In fact, the Fed’s interest rate hikes might contribute to inflation in some areas. Inflation is the result of a supply-demand imbalance. By dramatically raising interest rates, the Fed has made it more difficult for businesses to increase supply. Take housing, for example. The cost of a 30-year fixed mortgage has risen from 2.8% to nearly 7% in 2022, meaning the cost of home ownership has more than doubled. How will landlords compensate? By raising rents, not lowering them. Of course, this supply dampening is offset by significant impairment to demand through the “negative wealth effect” we’ve described before. By driving asset prices down, the Fed is engineering demand destruction through declining household-level net worth.
A recent report from the Committee for a Responsible Federal Budget (CRFB) highlights the significant divergence between monetary and fiscal policy’s efforts to fight inflation. They aptly point out that the Fed’s interest rate hikes only contribute to a worsening deficit, as interest expense is the fastest-growing segment of federal spending . A worsening deficit only further fuels inflation, as it becomes more likely the government will be unable to pay its debts in real terms. We’ve argued in previous posts that we are past the point of no return - inflating away the debt is the endgame, and the playbook is called financial repression.
Houston, We Have a Problem 🧯
Sovereign debt bubbles and the long-term debt cycle are typically far enough apart that most seem to forget their existence and, thus, how to spot one. Occurring roughly every fifty years, the latest (and largest) is already upon us. The United States, and most developed sovereigns, enjoyed five decades of easy credit expansion, whereby debt levels continuously rose, only sustained by ever-lower interest rates. Every crisis has been fought with more debt and lower rates; hence the term “kicking the can down the road" Unfortunately, inflation is debt bubble kryptonite.
Inflation has necessitated higher interest rates, partly due to central bank interest rate hikes but more so due to market participants demanding higher yields to compensate for the loss of purchasing power. It is pure folly to believe the federal government’s balance sheet or sovereign debt markets can survive interest rates much higher than they are now, as other G7 central banks are finding out.
If foreign central banks don’t follow in the Fed’s tightening footsteps, they risk watching their currency collapse as investors swap it for dollars to earn higher U.S. rates. Ask the Japanese – who’ve maintained a loose monetary policy and watched the Yen fall 23% versus the dollar this year, reaching its weakest level since 1990. A decline only slowed by the Bank of Japan’s forced and ongoing intervention to sell dollars for Yen.
Similarly, the Bank of England (BoE) had to intervene in its own sovereign bond market. The U.K. has elected to raise rates alongside the U.S. but, combined with an overzealous fiscal spending proposal, caused a historic selloff in gilts (U.K. government bonds), particularly long duration. The volatility unveiled the fragility of a derivative scheme called Liability-Driven Investment (LDI). Starved for yield over the last decade, U.K. pension funds have been forced to employ leverage to fulfill their obligations. Through the various flavors of LDI, the pension funds were highly levered to gilts, betting on persistently low interest rates. As gilts sold off, these funds faced massive margin calls to the extent that the entire financial system was at risk. Here are the words of the BoE’s Sir Jon Cunliffe:
“The Bank was informed by a number of LDI fund managers that, at the prevailing yields, multiple LDI funds were likely to fall into negative net asset value. As a result, it was likely that these funds would have to begin the process of winding up the following morning. In that eventuality, a large quantity of gilts, held as collateral by banks that had lent to these LDI funds, was likely to be sold on the market, driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability” .
The BoE stepped in as a buyer of last resort to stabilize gilt markets. While supposedly only temporarily, the central bank is printing money and raising interest rates simultaneously (?!). We suspect this won’t be the last of U.K. pension fund woes and that a similar bout of illiquidity might be coming to the U.S. Treasury market should the Fed continue on its tightening path. We produced the following chart in our last post and have updated it here for more recent data. Using this proxy, the U.S. government is facing rapidly increasing interest expenses.
When the Federal Reserve executes quantitative easing, it buys U.S. Treasury securities from banks by digitally crediting their accounts at the Federal Reserve, known as “reserve balances.” These balances are a liability of the Fed and payable on demand. Like a bank, the Fed borrows short and lends long, a duration mismatch that exposes them to interest rate risk.
Note - the following two paragraphs are a deep dive into Fed Financials; feel free to skip over the specifics to "Math aside..."
Per 2021 Federal Reserve financials, the Fed received $122.5B in interest income, of which $92B was from the U.S. Treasury and the remainder from its mortgage-backed securities (MBS) portfolio. Meanwhile, the Fed paid out interest expense to banks of $5.7B, leaving a net interest income of $116.8B. Under the Federal Reserve Act of 1913, the Federal Reserve must distribute its earnings back to the Treasury. Thus, after some operating expenses, the Fed returned $109B to the U.S. Treasury (more than the U.S. Treasury originally paid in interest on the Fed’s portfolio of Treasuries). This amount is not immaterial to the Treasury, given that net interest outlays for the Federal government in 2021 totaled $352B or 1.6% of GDP .
2022 will look quite a bit different. We’ll make some overly simplistic assumptions. The average Fed Funds Rate in 2022, provided the Fed hikes the expected 75bps in November, will be roughly 2%. Using its average liability balance year-to-date of $8.84 trillion, we estimate the Fed will pay approximately $175B in interest this year, a far cry from the $5.7B paid out in 2021. Meanwhile, its assets are mostly fixed coupons, so we can assume it will receive roughly the same amount in interest as it did in 2021 from its Treasury and MBS holdings - $122.5B. This napkin math results in an operating loss of $52B, and if we use the Fed’s desired terminal rate of 4.5% for 2023 on the same balances, we get a loss of $275B. Federal Reserve accounting rules stipulate these losses accrue as a “deferred asset.” Once the Fed returns to profitability, it would first pay down the deferred asset before remitting any excess earnings back to the Treasury. Long story short – the Treasury will likely never again receive income from the Fed. These are significant swings. The U.S. Treasury will go from receiving a net income of $17B to being short $92B, or a $109B swing, which using 2021’s net interest outlay figure, will increase 2022 figures by 31%, and that doesn’t factor higher interest rates on newly issued debt.
Math aside – the picture we are painting is one of increased Treasury issuance to “plug the gap.” We haven’t even discussed the increased Social Security costs due to the “cost of living adjustments,” healthcare inflation, an increased defense budget, and the cost of financing continued fiscal spending. The question is, who will buy these Treasuries? Historically, the largest buyers of U.S. Treasuries are foreign central banks, depository institutions (banks), and, in recent years, our very own Federal Reserve through QE operations. Today there is little to no demand from any of these buyers; most are selling. The Federal Reserve is selling Treasuries as part of their planned “quantitative tightening” measures. Most foreigners have also been selling Treasuries to defend their currencies. Large banks have also been net sellers since March 2021, when the Fed removed the temporary “Covid” exemption of Treasuries under the Supplementary Leverage Ratio (SLR).
The loss of core buyers in the U.S. Treasury market has left the world’s single most important market remarkably illiquid and subsequently volatile. The MOVE index, a well-known measure of Treasury bond market volatility (similar to the VIX for equities), has consistently printed readings that rival those during the March 2020 Covid crisis. Treasury Secretary Janet Yellen said last week, “we are worried about a loss of adequate liquidity” in the Treasury market. In addition, Treasury auctions have seen bleak demand. A key measure called the bid-to-cover ratio in a recent 10-year note offering was more than one standard deviation below last year’s average . All this to say—the cost of borrowing for the U.S. government continues to rise at a historic pace. We firmly maintain this is unsustainable and expect to see actions taken to improve Treasury market functioning, which should help stabilize global markets. Supportive measures may include the Treasury buying back its own debt, the Fed re-instituting the SLR exemption to incentivize banks to hold more Treasuries, and of course, outright purchases by the Fed itself (aka quantitative easing).
A hallmark of financial repression is negative real rates; by maintaining interest rates below the inflation rate, the Federal Government is silently taxing savers to reduce its debt burden gradually. As we argued in our first section, the government will continue to drive high nominal GDP growth through structural inflation. In a recent interview, Scottish market strategist, Russell Napier, describes how governments have taken control of money creation through the issuance of state guarantees on bank credit. He cites the following statistics on bank loans to corporates in the EU since February 2020: “of all the new loans in Germany, 40% are guaranteed by the government. In France, it’s 70% of all new loans, and in Italy it’s over 100%, because they migrate old maturing credit to new, government-guaranteed schemes” . Through credit guarantees, the government can indirectly impact investment to select areas of the economy, politicizing the distribution of credit. Napier believes central banks are relatively useless in this environment. As he so eloquently puts it, “There’s another way of looking at today’s loud, hawkish rhetoric by central banks: Teddy Roosevelt once said that, in terms of foreign policy, one should speak softly and carry a big stick. What does it tell you when central banks speak loudly? Perhaps that they’re not carrying a big stick anymore.” 
Our bias continues to be for structural inflation settling into the 4-6% range and real rates being solidly negative, meaning nominal interest rates near 2-3% due to government and central bank intervention. This macro setup favors real assets, including precious metals, commodities, and equities (some sectors more than others), and Bitcoin. However, in the short term, markets will first have to weather the remainder of Hurricane Powell. Ironically, with every market attempt to front-run a Fed pivot, the more license the Fed has to keep tightening. We look forward to an environment that isn't so dependent on the words of a single unelected official.
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All financial data is sourced from Refinitiv unless otherwise noted.
 Burns, Arthur. The Anguish of Central Banking. 1979.
 Committee For A Responsible Federal Budget. Fiscal Policy in a Time of High Inflation. October 13, 2022.
 Cunliffe, Jon. Letter to the Chair of the Treasury Committee. Bank of England. October 5, 2022.
 Federal Reserve Banks: Combined Financial Statements. As of and for the Years Ended December 31, 2021 and 2020 and Independent Auditors’ Report.
 Congressional Budget Office. The Federal Budget in Fiscal Year 2021. September 20, 2022.
 Burgress, Robert. The Fed's Next Crisis is Brewing in U.S. Treasuries. Washington Post. October 17, 2022.
 Napier, Russell. Interview with themarcket.ch. October 14, 2022.