During yesterday's surprisingly candid remarks by Bill Dudley, the second most important person in the Federal Reserve - the organization that is responsible for the third consecutive and largest ever yet asset bubble in history - said that one risk he was increasingly worried about was, drumroll, elevated asset prices. Because, supposedly, the Fed has little to input in how asset prices came to be where they are...
Just as ominous was Dudley's admission that the second risk he was concerned about is "the long-term fiscal position of the United States" i.e. US debt. Specifically, Dudley said that the Trump tax cut "will increase the nation's longer-term fiscal burden, which is already facing other pressures, such as higher debt service costs and entitlement spending as the baby-boom generation retires."
Oddly there was no mention of which administration doubled US debt from $10 trillion to $20 trillion in under a decade, and which organization enabled this to happen by keeping rates at record low levels, while crushing savers, and bailing out habitual gamblers.
In any case, now that the narrative has shifted, and Donald Trump will be scapegoated not only for the upcoming "tremendous" market crash - something he has made especially easy by taking credit for every single uptick in the S&P - but also for the inevitable fiscal collapse of the United States, it is time to provide the backing for this particular strawman, and to do that, this morning Dudley's former employer, Goldman Sachs released a report in which the bank's chief economist said the he is updating his Treasury issuance forecast to account for recent revised deficit projections. As a result, US marketable borrowings will more than double from below $500 billion in 2018 to over $1 trillion in 2019 as the debt tsunami finally get going.
To build up the strawman, Goldman explains that US borrowing needs will rise for three reasons:
- First, recently enacted tax reform legislation is estimated to raise the deficit by more than $200bn, on average, each of the next four years, and Congress looks likely approve substantial new spending as well.
- Second, Fed portfolio runoff will increase the amount of debt the Treasury must issue to the public.
- Third, the Treasury’s cash balance is likely to rise by around $200bn once a longer-term debt limit suspension is enacted, which will also necessitate additional borrowing.
Goldman expects that the "substantial increase" in borrowing needs will be announced by the Treasury when it lays out its plans at the February quarterly refunding.
What Goldman has left unsaid is what happens to interest rates at a time when on one hand US debt supply is set to double and on the other the Fed is set to continue shrinking its balance sheets, the ECB and BOJ are set to accelerate (and begin) tapering their own QEs and when global inflation is expected to keep rising.
What is also unsaid is just who will be the marginal buyer of this debt tsunami when central banks increasingly shift away from debt monetization.
What is certainly unsaid is what "market event", a la Lehman 2008, will be used to unleash QE4 in order to bring the Fed back into the deficit funding business once it becomes all too obvious that borrowing spree the US is about to set off on is unfeasible absent a central bank monetizing the new supply and keeping rates low.
We look forward to the answer being revealed in the not too distant future.
For now, however, here is Goldman's explanation why US debt supply is set to soar by more than 100%.
Raising Our Treasury Issuance Estimates
Ahead of the February quarterly refunding, we are updating our Treasury issuance estimates. We expect net issuance of marketable Treasury securities to roughly double in FY2018 over the FY2017 level, for three reasons:
- We expect the budget deficit to rise. We project a deficit of $750bn (3.7% of GDP) in FY2018 and $1050bn (5%) in FY2019, compared with $666bn (3.5%) in FY2017 (line 1 of the table in Exhibit 1). The main factor behind the increase in the deficit we expect is the recently enacted tax legislation, which more than offsets the fiscal effects of an improving economy. We also expect Congress to approve additional spending. Two installments of disaster relief funding have already been approved and a third is likely to pass soon; in the next month or two, Congress is also likely to approve a roughly $100bn increase in the caps on regular appropriations, which should lead to a similar increase in spending spread over the next few years.
- The Treasury’s cash balance shrank in FY2017 but is likely to increase in FY2018 because of the debt limit. Over the last few years the Treasury has aimed for a cash balance of $350bn to $400bn when the debt limit is not a factor but reduced the balance to $150bn to $200bn for most of FY2017 as a result of constraints imposed by the debt limit. We expect Congress to suspend the debt limit once again by March, probably through mid-2019. Once the debt limit has been suspended for a longer period, we expect the cash balance to rise to around $350bn. This will require nearly $200bn in additional borrowing in FY2018 in particular (line 8 of the table in Exhibit 1).
- Fed balance sheet runoff leaves more for the market to absorb. We estimate that $378bn in Treasuries held on the Fed’s balance sheet mature in FY2018 and $412bn will mature in FY2019 (line 2b of the table in Exhibit 1). In light of the FOMC’s policy to reinvest maturing securities only if principal payments exceed gradually rising caps, we expect balance sheet runoff to add $179bn to the Treasury’s marketable borrowing in FY2018, and $286bn in FY2019.
As a result of these factors, we expect net marketable borrowing to increase from $488bn in FY2017 to $1030bn in FY2018, and we expect a similar level of net borrowing in FY2019 (line 13a in Exhibit 1). The increase in financing needs is likely to be addressed through increases in bill and coupon issuance. The most recent quarterly refunding statement, released in November, indicated that the Treasury will increase bill supply and announce a gradual increase in coupon and FRN auction sizes at the February refunding. The Treasury also indicated that it is likely to fulfill its upcoming issuance needs in a manner that keeps the weighted average maturity (WAM) of its outstanding debt roughly stable. This comment came as a surprise to many fixed income investors. The Treasury has extended WAM for roughly a decade, and many investors assumed it would continue to do so at least modestly and perhaps even more materially if Treasury Secretary Mnuchin followed through on his comments earlier this year in favor of ultra-long issuance.
Exhibit 2 shows our estimates of net bill issuance plus gross issuance by security through 2021. In the current fiscal year, we expect that net bill issuance will be used to close the majority of the new issuance that will be necessary over the FY2017 level. This is in large part due to the fact that the Treasury has kept coupon auction sizes unchanged since the start of the fiscal year in October 2017. However, once coupon auction sizes are increased, which we expect to be announced at the February refunding, bills will make up a slightly smaller share of new issuance. In FY2019, for example, we expect the increase in net bill issuance over FY2017 to close about 1/3 of the financing gap (i.e., the difference between the new money that would be raised using current auction amounts and the projected financing need), in line with the TBAC recommendations. Most of the remaining gap would be made up through additional issuance of 2-year, 3-year, and 5-year notes. We expect the Treasury to take the initial steps in this direction next month when it makes its quarterly refunding announcement.
Finally, in light of the unspoken message, which for anyone confused is that interest rates are about to spike, here is the only quote that matters from future Fed Chair Jay Powell, who made the following prophetic observation during the October 2012 Fed meeting.
I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
You almost can, because "down the road" is finally here, and rates are about to come up. As for those "big losses" from record duration, don't worry - by the time someone has to deal with the fallout, they will be someone else's problem...