3 Key Takeaways
- The US has a ton of debt, and it’s growing extremely fast
- The interest on the debt is manageable as long as the fed keeps rates low
- Eventually the Fed will print too much money, so watch 3 key indicators
Note: This article may be updated as the Covid-19 crisis continues to unfold. The situation is evolving quickly and the amount of debt being added in weeks was expected over years. Any updates will be added to the end of this article, so the core of the article should remain relevant.
The US Federal Government has a ton of Debt!
As of May 2020, the total outstanding debt was over 25 trillion, $6 trillion of which the government owes itself, mostly to the Social Security Trust Fund. To better understand and analyze the debt, I scraped data from the US treasury website as well as the St Louis Fed to bring the data into a consolidated dashboard that I used to create the plots on this page.
In recent years the debt has started to explode higher as total debt has risen above US GDP for the first time since World War 2. This trajectory can be seen in Figure 1 below.
Figure 1: Historical US Federal Debt (source St. Louis Fed)
Figure 2 shows the amount of debt added in each calendar year. Under normal circumstances, this growth in debt would usually result in rising interest rates, putting pressure on government spending and force the borrower into a more conservative state. This would also be highly deflationary as the debt is restructured and investors are required to take a haircut. That being said, “normal circumstances” do not apply to this situation and interest rates have been going down not up.
In the chart below, you can see the spike in debt issued during the Financial Crisis of 2008, then a drop off, but never returning to pre Great Recession levels. Since 2018, the growth of debt started increasing again with a massive surge in 2020 due to Covid.
Figure 2: Annual increase to the Federal Debt
An Increase in Supply coupled with a fall in Demand usually leads to higher prices
Bond prices and interest rates move inversely to each other. As interest rates, fall the price of bonds increase. As can be seen above, the supply of bonds issued has increased substantially in recent years. To issue this debt, the Treasury holds auctions where it issues Bills (debt maturing in less than 1 year), Notes (1-10 year maturity), and Bonds (greater than 10 year maturity). Primary Dealers (Banks) will bid on the debt being issued, offering a certain interest rate based on the terms of the auction. The Treasury reviews the bids and issues the debt to the most favorable rates.
The demand for bonds can be seen in the Bid to Cover ratio which shows the amount of bids in excess of the debt being auctioned. The Treasury posts the results of every auction on the website and discloses the bid to cover. This data will show three critical variables: the supply, demand, and the price. The three figures below would confound anyone who just completed a course in Econ 101.
Figure 3, the Supply, shows the total amount of debt issued. The figure won’t match Figure 2 because Figure 3 will include debt that is rolled over. When you compare the two charts, it is striking just how much debt the Government rolls over each year! For example, the government issued $12 trillion in bonds for 2019 even though the debt only increased by $1.3 trillion. This creates substantial risk to a rise in interest rates as the debt will be rolled over at higher rates.
Figure 3: The Supply of debt being issued
Figure 4 shows the Demand by plotting the average Bid to Cover Ratios overtime by maturity. This shows the dollar amount in bids from the primary dealers divided by the amount of debt auctioned.
Figure 4: Demand for debt from the Primary Dealers
As can be seen very clearly in the two charts above, as the supply has increased, the demand has failed to keep up. Quite strikingly, the results of the mismatch in supply and demand has not shown up in the price.
Figure 5 below shows the average weighted rate/price paid by the primary dealers. While Figure 5 shows an initial uptick in rates in late 2016, there is a sharp drop in rates as the supply and demand curves start to really diverge. The price below is exactly opposite of what someone would expect to see based on the supply and demand shown above.
It is critical to note that these charts are as of May 11, 2020, before even reaching the midway point of the calendar year. 2020 is on pace to be far bigger than even 2019, which was the largest on record for issuance (not for actual debt added as can be seen in comparing Figure 2 and Figure 3).
Figure 5: Price, the rate Primary Dealers agree to receive on the loan
Enter the Federal Reserve
In a vacuum, the charts above are completely counterintuitive: increase in supply and falling demand should lead to lower prices (higher interest rates), not higher prices. However, anyone who even casually watches the news can point to the primary driver of the divergence. The Federal Reserve can control the interest on short term rates through monetary policy. The fed dropped rates to zero in 2008, raised them slowly from 2016-2018, before cutting rates again in 2019. The market could not handle the higher short term rates.
While the Fed can control short term rates, it is harder to control longer term rates with standard monetary policy. This is where Quantitative Easing comes in. The Fed prints money to buy long term Treasuries, creating artificial demand that pushes prices higher which lowers interest rates.
In response to Covid 19, The Federal Reserve has committed to unlimited Quantitative Easing, to absorb all the debt being issued. When Primary Dealers know they can buy a bond and sell it to the Fed, they are willing to accept a much lower rate of return because the risk to the bond holder has collapsed to essentially zero.
How much money is the Fed willing to print? One look at their balance sheet tells the entire story.
Figure 6: Federal Reserve Balance Sheet
The Fed balance sheet has exploded in recent weeks similar to the way it did in the early 2010s to absorb the large issuance of debt from the Financial Crisis. Figure 7 shows more detail at the type of Treasuries being purchased, and it quickly becomes clear they are buying long dated maturities to keep the yields low on longer term debt. The Fed already has control over shorter term debt using normal monetary policy. Putting all the charts together, shows the Fed has essentially bought up every dollar of long term debt issued by the Treasury since the start of the Corona virus. Even before the virus they were starting to buy up debt to try and keep control over the debt market.
Figure 7: Breakdown of Federal Reserve Treasury holdings
So, When will the US Debt Bubble Pop? - It won’t
As mentioned above, under normal circumstances, when debt balloons the way it has, lenders put constraints on borrowers by charging higher rates, which would be deflationary. This should have happened several years ago, but the Fed has kept tight control over the market, keeping rates in check. It has no other choice.
The Federal Government is incapable of cutting spending. If rates were to increase on such a massive debt load, the government would quickly run into trouble as interest on the debt begins to soak up more and more of Federal Revenue. Figure 8 below shows that this clearly has not happened. This shows interest paid on debt held by the public (ignoring the $6 trillion the government owes to itself). It also shows how much of the annual Federal revenue goes towards servicing that debt, which has held constant between 8-11%. If servicing the debt were to get too high, that is where the debt spiral begins to lead to an unsustainable situation. Debt would be restructured and deflation would take hold.
Figure 8: Interest paid on the Debt
Figure 8 clearly shows how important the Fed has been to keeping interest rates under control. Without the Fed, the black line above would start to move up and the debt would become unwieldy. This is why interest rates will NEVER return to “normal”. The Treasury knows this, otherwise it would be issuing much longer term debt to lock in low interest rates far into the future.
Looking back at the auction data, 83% of debt issued in 2020 has been in Bills (maturing in less than 1 year). In previous years, that number has been closer to 75%. The Treasury knows they cannot issue more long term debt without putting more pressure on the Fed. Instead, they issue short term debt which is generally well accepted by the private market where the Fed can control the interest rate using the Federal Funds rate instead of having to actually buy the debt.
Can this go on forever?
I do not believe so. Either interest rates will eventually rise causing default and restructuring (deflation), or the Fed will print too much money (inflation). I think the latter is most likely. The Treasury has taken tremendous risk by keeping so much debt in short dated maturities. Looking again at Figure 8, the Fed raised rates from 2017 to the end of 2018. Interest as a % of Revenue shot from 8% to 11% within 18 months. That occurred in a “strong” economy where Federal Revenue and GDP were both increasing. During a recession, everything reverses. Debt increases as revenue falls. If the Fed does not intervene, the debt bubble would pop very quickly. The Fed has no choice, it either lets the US Government default causing deflation, or it prints the money.
The Fed will print and eventually inflation will appear. If printing money was a viable solution, then any country with a printing press would be incredibly prosperous. However, while the dollar is the reserve currency, the Fed has far more room to maneuver than any other country. If the reserve currency is challenged then inflation could get out of control very quickly.
The real question - Will the dollar lose its status as the reserve currency?
All fiat currencies collapse. Sometimes over centuries, but often times much sooner. As they say, “How did you go bankrupt?”. “Very slowly at first, and then very quickly”. I am watching three key indicators on my Dashboard, and the CPI is not one of them. I think the CPI generally understates inflation
Five years ago, I would have said that China and Japan could single handily crash the dollar, each holding $1T+ in US treasuries as shown in Figure 9. The landscape has changed some, as the Federal Reserve just absorbed $2T in US debt within a month (Figure 7). I no longer think that China could crash the Treasury market because the Fed has promised to buy the debt. Instead, a draw down in Treasury reserves around the world would be an indication that people no longer want dollars. Therefore I am still watching their debt holdings that will signal a move away from dollars. Unfortunately, this data only updates monthly and on significant delay.
Figure 9: Indicator 1, International Holders of US Treasuries
The second indicator is the dollar index shown in Figure 10. This will show the demand for dollars around the world. Unfortunately, the Dollar Index is compared to other fiat currencies that are all in a race to the bottom, as politicians compete to see who can promise more free stuff. On its own, the Dollar Index is not completely reliable because other countries can outprint the Federal Reserve if they choose to. Therefore, the last and most important indicator is the price of gold.
Figure 10: Indicator 2, The Dollar Index
Gold is one of the most controversial topics and investments, but mostly because people do not understand its role. Gold is not a stock that generates revenue and creates growth. Gold is not a bond that provides income to its holders. Gold is the ultimate currency and the best insurance policy against government incompetence. Any cash position I hold is split between gold and US dollars. Therefore, by watching the price of gold (Figure 11), I can see the true purchasing power of dollars when compared to the true reserve currencies of human history.
Figure 11: Indicator 3 - The Price of Gold
Wrapping up
In conclusion. The Fed will not let the US Debt bubble pop, it will try to walk the precarious line of printing enough money to keep rates under control and deflation at bay while not letting inflation get too high. This is a dangerous game and an extremely hard line to walk in perpetuity. Eventually the Fed will slip, and fall to one side or the other. In late 2018, the Fed almost went too far by letting rates rise and immediately back tracked. Going forward the Fed will err on the side of printing money.
COVID-19 Updates
Updates will be forthcoming
Disclosure: The content herein is my own opinion and should not be considered financial
advice or recommendations. I am not receiving compensation for any materials produced.
I have no business relationship with any companies mentioned.