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The dramatic rise in U.S. Treasury yields, particularly the long end of the curve, stole the show this quarter. U.S. government issuance has risen dramatically, while demand for U.S. Treasuries has weakened, creating a supply/demand imbalance. Unfortunately, higher interest rates reflexively worsen the government’s fiscal position, which will put further upward pressure on Treasury yields. As Paul Tudor Jones recently highlighted:
“As interest costs go up in the United States, you get in this vicious circle, where higher interest rates cause higher funding costs, cause higher debt issuance, which cause further bond liquidation, which cause higher rates, which put us in an untenable fiscal position.”
TLDR - “too long; didn’t read.” We recognize our posts can be lengthy, so here’s our executive summary:
- The government running recession-level deficits (spending) has been driving the “resiliency” of the economy in the face of higher interest rates.
- Several pandemic-related government support programs have recently expired or are set to phase out, further pressuring the U.S. consumer, who is already struggling to combat persistent inflation.
- Assuming the absence of further stimulative programs, we foresee the U.S. economy entering a recession (defined as two consecutive quarters of real GDP contraction) in the first half of 2024.
- To support elevated spending levels, rising interest service costs, and debt refinancing, the U.S. government will have to issue a waterfall of Treasuries over the next several years. The private sector does not have the balance sheet capacity to absorb the sheer quantity of new debt.
- To compensate, interest rates will continue their rapid ascent higher, or the central bank will step in as a buyer of last resort. Most likely, both will occur in said order.
- The next episode of the “printing press” will be more inflationary than the last.
Sink or Swim 🥽
“There is nothing as permanent as a temporary government program” – Milton Friedman.
The government has been spending as if we’re still actively fighting the pandemic. Despite the strong post-pandemic economic recovery, many temporary government aid programs have continued. In 2023, this spending has been life support for an economy on the brink of recession. Only recently have some of these programs ended, which will likely deal the knockout blow to the “resilient” U.S. consumer. Here’s an inconclusive list:
- Medicaid Grace Period – As part of the Families First Coronavirus Response Act (FFCRA), Medicaid programs were required to keep participants continuously enrolled in return for enhanced federal funding. This provision ended in March of 2023, and an estimated 8 million to 24 million will lose coverage during the 12-month unwind period.
- Economic Injury Disaster Loans – These were available to small businesses during the pandemic with repayments deferred for 30 months (but accruing interest!). Nearly 4 million businesses received $378 billion in loans, the bulk of which are only now beginning the repayment period.
- Student Loan Payments – The government enacted a moratorium on all student loan payments in response to the pandemic, which was effectively a monthly stimulus check for the over 40M Americans with student debt to the tune of $390/month on average. As of October, student loan payments have re-started, which will be a headwind of nearly $16 billion per month for consumer spending.
- Finally, the most egregious of them all – Employee Retention Credits (ERC) – This tax credit was available to small businesses that retained employees during the pandemic. Despite positive initial intentions, this program has been fraudulently abused to the extent the IRS has paused processing pending further review. An entire industry arose overnight to badger individuals to apply for these credits, up to $26,000 per employee, often conning people into fraudulent claims while collecting 30% processing fees. In 2023, ERC payments amounted to $103 billion, up from $82 billion in 2022, while the combination of 2020 and 2021 saw just $45 billion in payments1. You read that correctly – the IRS has made four times as many ERC payments in the last two years post-pandemic as it did during the pandemic.
These are just the consumer headwinds associated with removing government assistance programs. Meanwhile, inflation has been eating away at U.S. households’ discretionary income, as the cost of living, per the CPI, has risen 19% since the end of 2019. U.S. consumers have responded by putting it on their tab, as credit card balances are up 26% since the end of 2021. Interest rates on credit cards are up nearly seven percentage points over the same period, driving interest expense up 46%, a double whammy.
The strength of the labor market has confounded many economists. Unemployment stood at 3.8% in September, ticking up slightly from a multi-decade low of 3.4% in April. However, the labor force participation rate, now 62.8%, is still below pre-pandemic levels of 63.4%. We believe the rise in unemployment has only just begun due to the lagged effect of higher interest rates on corporations and the economy at large. WARN notices, which require large employers to give advance notice of layoffs to state governments and workers, highlight an upcoming rise in jobless claims.
The labor market is usually a lagging indicator and rolls over once recessions are underway. The yield curve remains inverted (short-term rates higher than long-term rates), an undefeated predictor of recessions. More problematic is the tendency of the yield curve to un-invert just before the onset of recession, which is currently the case. The Federal Reserve Bank of New York yield curve analysis has the probability of recession at 56%.
We expect this recession to be, at least initially, stagflationary (demand ↓, prices ↑), which is unique to recent recessions in the U.S. Stagflation is a recipe for declining corporate earnings margins, which may pressure market consensus estimates of 8.5% earnings growth for the S&P 500 in 2024.
All this spending talk leads to our next section – how can the government afford it!? U.S. government debt to GDP stands today at just under 120%, with total debt outstanding of $32.3 trillion and counting. In May, the Congressional Budget Office estimated the U.S. will run a deficit of $1.4 trillion this year, of which $640 billion would be attributable to interest expense. Rising interest rates will significantly increase that figure through the end of this year and into next year. Using the following proxy, we estimate interest expenses of $1.68 trillion over the next twelve months.
Using our interest expense estimate for 2024 and the Congressional Budget Office estimates for government revenues and non-interest related government expenditures, we calculate a deficit of nearly $2.6 trillion or 9.4% of GDP next year. This wartime deficit run during peacetime does not account for the increased likelihood of even greater spending as conflict now heats up in the Middle East on top of the existing Ukraine military aid efforts (see our earlier piece on global conflict). For context, during the depths of the Great Financial Crisis, the U.S. government deficit reached 9.75% of GDP, not much greater than current levels. We pose the question – where might deficits go during the next recession? Roughly speaking, up, up, and away.
To fund deficits, the government must issue U.S. Treasuries. However, issuance levels are already elevated largely due to re-financing existing debt. For reasons we’ll never understand, the Treasury Department elected to issue primarily short-term debt during the low-interest rate environment. This leaves a large percentage of debt outstanding to be “rolled” at much higher interest rates relatively soon. Here’s a look at the U.S. debt maturity schedule, where nearly $12 trillion needs to be refinanced by the end of 2025.
To make matters worse, we must account for deficit financing, which we estimate as a total of $5 trillion through 2025, which brings total gross issuance to somewhere near $17 trillion in the next 27 months. The private sector balance sheet has zero ability to absorb this issuance amount. These figures don't factor in existing holders of Treasuries selling, thereby increasing net effective issuance, as the market must also absorb those sales. The Federal Reserve is currently one seller through its quantitative tightening program. Secondly, foreign central banks are typically sellers of U.S. dollar assets to defend their currencies during periods of dollar strength, which has been the case as of late, with the dollar up 4.2% since the end of July.
Who will buy the debt? We suspect a combination of several factors. First, longer-term rates must move significantly higher to entice natural buyers in the private sector. This will crowd out other investments and, all else equal, be a headwind for equity markets. We are already hearing pensions with long-dated maturities are eager to lock in higher interest rates. Secondly, banks have and will continue to be buyers of debt due to regulation, which will likely continue to change at the margin to force banks into owning more Treasuries, a hallmark of financial repression. Lastly, we believe the Federal Reserve will ultimately be forced back into its role as buyer of last resort, further expanding its balance sheet. All roads lead to further money printing and currency debasement to keep a lid on yields, but in the interim, we expect the rise in long-term yields to continue, pressuring the economy and financial assets. When might the rubber hit the road? We are watching Overnight Repurchase (Repo) Agreements, which totaled $2.25 trillion at the end of May and are now just $1.1 trillion2. The draining of this facility has absorbed significant Treasury bill issuance since the debt ceiling extension, and when it runs dry, Treasury demand will be even softer.
As for Federal Reserve policy, we suspect the most recent interest rate hike was the last but caution not to mistake the completion of the hiking cycle for easy policy. Jerome Powell is dead set on higher for longer and will do anything to keep rates elevated. The Fed’s swift and decisive action during the regional bank crisis in March was evidence to that effect. By creating the Bank Term Funding Program (BTFP), Powell helped banks in need avoid marking their losses to market and paved the way to continue his hiking crusade. We believe the Federal Reserve will have to see a seizing of credit markets to be forced into easing. For clues on timing, we look to the corporate credit markets.
The government won’t be the only entity rolling their debt, as corporations have their own maturity wall on the horizon. Goldman Sachs estimates roughly $3.25 trillion of corporate debt matures between now and the end of 2026. Most of this debt was issued at interest rates far lower than prevailing rates, and as a result, companies will be spending a higher percentage of revenues on interest expense. Subsequently, they will be cutting costs elsewhere. Goldman Sachs found for every dollar increase in interest expense, firms cut 10 cents in CapEx spending and 20 cents in labor, which they estimate equates to 5,000 jobs per month lost in 2024 and 10,000 per month in 2025. These are collective figures; therefore, individual unprofitable/highly leveraged firms will feel the squeeze of higher interest rates far more acutely.
The great re-financing will not be pretty. It’s a natural evolution of the global exit from zero interest rate policy. We await whether the central banks will kick the can down the road again, a Wall Street favorite, but fear another stimulative episode may leave the inflation genie irreversibly out of the bottle. There’s no such thing as a free lunch, and the people are starting to connect the dots.“An explosive rise in velocity thus accurately marks the point of obliteration of an inflated currency, but it does not cause itself. People cause velocity, and they only cause hypervelocity after prolonged abuse of their trust”. -Jens Parsson in Dying Money: Lessons of the Great German and American Inflations (1974).
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1 Hedgeye Research.
2 FRED Data. Overnight Repurchase Agreements.