A recent detailed analysis of the composition of US Federal debt has made us question just how much dry powder the Fed has left to manipulate interest rates. We ignore all tangential issues such as what the end of QE will mean on MBS, and by implication 10 Year, rates, and focus purely on the structural composition of the curve, which leads us to some very troubling observations. In summary: the Treasury is running out of time in which to orchestrate a massive rush away from risky assets into the sweet spot for UST interest rates: risk-free Bill holdings. In other words, a stock market crash is long-overdue if the Treasury does not want to face a major spike in rates and drop in Treasury demand in the immediate future.
First, and this is no surprise to anyone, the US is on collision course with an unmitigated funding disaster. As the chart below demonstrates, the US has been issuing roughly $147 billion a month for the past 17 months, in a period in which total US Federal debt has increased from $10 trillion to $12.6 trillion. With recently passed healthcare reform, look for the red line indicating total debt to go increasingly exponential.
Like we said, nothing surprising here as we spend ourselves into bankruptcy. The only reason why this has not escalated yet has been the Fed's ability to keep rates low on the short end, translating into modest low long-end rates as well, despite the curve being at record wides. The progression over time of average interest rates by Bills, Notes and Bonds, as presented by Treasury Direct, is shown below. This should also not come as much of a surprise, as it has been well known that the Fed's only prerogative in the past two years has been to buy every yielding security in sight to keep rates low.
Now where it gets quite interesting is an analysis of the composition of the total components of the debt, on a relative basis. The chart below demonstrates the amount of various pieces of debt by tenor as well as the inclusion of non-marketable debt and trust funds held by the Treasury.
Recreating the chart above, but focusing exclusively on Marketable debt, yields the following chart:
We wrote recently that while China may or may not be bailing on US debt, one thing that is certain is that it is not rolling, and in fact may well be selling, its Bill exposure, i.e., short-term Treasuries that mature within a year.
Indeed, the recent scramble away from Bills is confirmed by the prior two charts which indicate that the portion of Bills as percentage of total marketable debt has fallen from 30.1% in February 2009 to just 21.8% in February 2010. The reason for this is that the Fed had been previously posturing that it is attempting to push the average debt maturity from 4 to 6 years and over. In order to do this the Fed needs to issue less net Bills. And therein lies the rub.
As rates have fallen, the average interest on Bills has dropped from 1.4% in October to essentially zero over the past several months (0.2% to be precise). In effect, the Treasury gets the benefit of holding $1.7 trillion in debt which pays no interest. Yet as its rolls out of Bills, its ability to take the implicit benefit of the Fed's ZIRP disappears. As the Fed's monetary policy impacts most of the the interest rate on Bills, with Bonds and Notes much more a function of medium- and long-term inflation/deflation expectations (and with the yield curve at record levels, the expectations see some less than smooth sailing down the line), as the Treasury rolls down its Bill holdings, as it has been doing, the Fed's ability to influence rates is getting progressively less and less. Couple this with an ever increasing record amount of total US debt, and you have a recipe for disaster, or as we call it, the curve Black Swan.
In fact this can be seen in the chart below: a comparison of average blended interest rates, and overall (accrued) implied monthly interest, demonstrates that even as the blended interest rate has dropped to an all time low of 2.57%, the actual annualized cash out on marketable debt (excluding the Trust Fund shell game), has returned to levels last seen in December 2008, of about $204 billion per month. The last time the annualized interest was this high, the actual interest rate was 3.2%, or 60 bps higher! Furthermore, even as rates have been declining, actual interest expense has been increasing consistently since May of 200 (and all this even as the actual blended interest rate is at an inflection point: it will likely trough in the mid 2.5% range as the low hanging Bill fruit has been plucked away).
The reason for this: 1) rates on Bills can only go 0.2% lower before hitting zero, and 2) nobody wants Bills anymore. China certainly has been selling Bills, and US citizens, balking at money market rates, are definitely not going to lock their money into Bills which yield the same if not less. The Treasury's natural response - bringing back the SFP 56-Day Cash Management Bills back. Today, the Treasury auctioned off the 5th $25 billion SFP chunk, on its way to filling up the $200 billion CMB tank full. Yet this is merely a stop-gap measure, and it is responsible for the slight bump higher in February Bill holdings compared to January. Alas, the Treasury will need to generate wholesale interest for Bills in some way in the near future, or else it will drown itself in the vicious cycle combination of increasing interest payments pushing rates higher, etc. And what creates a scramble for Bills better than anything?
Why a massive market crash of course.
Are we predicting one will happen? Of course not; in this market what is expected to happen is that last thing that will happen. We merely point out the logic and what the empirical evidence is demonstrating. Either the Treasury will need to expand the SFP program to far beyond the $200 billion cap, or it will need to get rates on Notes and Bills even lower at a time when the broader market is already expecting a rise in Rates. And in the meantime, it will continue issuing roughly $150-200 billion in debt each and every month to fund in increasingly bankrupt government.
What we can predict with certainty, is that the Treasury is on an inevitable collision course with insolvency, courtesy of a government run amok. And absent a major shift in capital out of risky assets into risk-free equivalents, it is going to get increasingly more difficult to control the runaway beast of rabid and uncontrollable deficit spending.