U.S. debt crisis assured...

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A Debt Crisis Is Locked In

Our friend Adrian Day checks in with a sobering analysis of the current U.S. debt situation — and where it will soon lead.

Editor’s Note: I am fortunate to count many of the smartest market and macroeconomic analysts of recent history as friends, and none more experienced and insightful than Adrian Day.
 

I’ve known Adrian for decades and can share that he has gotten only more eloquent and pointed in his analyses as the years have gone by, as evidenced by his recent letter to subscribers outlining the debt trap now unfolding in the U.S.
 

I enjoyed Adrian’s report so much that I asked if I could republish it for my Golden Opportunities subscribers, and he graciously gave his approval. I strongly urge you to give it a read, and to consider subscribing to Adrian’s excellent letter via the information at the end of this article.
 

— BL

U.S. Debt Crisis —
Even With Debt Ceiling Increase

A U.S. debt funding crisis lies ahead. J.P. Morgan CEO Jamie Dimon has warned that if the U.S. doesn’t take action to address the spiraling national debt, “you are going to see a crack in the bond market” (though he added that he doesn’t know when).
 

I believe we shall have a foretaste later this year, probably by the end of summer. This is not just me saying that; Treasury Secretary Scott Bessent has said as much. When I refer to a “debt crisis”, I am not referring to a default, or interest rates at 20%, or a dollar losing half of its value. This is not the “great reckoning”, not yet anyway. But it will be significant, for the economy and markets.

Debt Service Payments Set To Rise

With the national debt approaching $37 trillion, that’s over 120% of GDP (and nearly $280,000 for every household). That debt does not include the off-balance sheet liabilities that any private company would have to include. Add those in, and estimates for the total debt range anywhere from $130 trillion to $200 trillion. Over the last half century, U.S. GDP has increased by over 2,000 %, while government debt has increased by some 8,500%. That interest on the debt has increased by “only” 5,600%, is because rates were declining for most of this period (1980 to 2022).
 

However, debt service as a share of GDP have been increasing for the last several years and are now back up to just over 3%, almost at the record level they were in 1980, when interest rates were four times what they are today. Interest rates fell from over 15% in the 1980s to zero lower bound in 2016 before moving back up to 4.5% today, helping to reduce interest payments even as the total debt increased.
 

Now the reverse is true. As the shorter-term five- and seven-year Treasurys issued at far lower rates mature, they have to be rolled over at higher rates today, ensuring that the interest payments, in both absolute and relative terms, increase. Debt service is estimated to be 17% of next year’s budget, larger than the defense budget, or Social Security, or Medicare, indeed the largest single item in the federal budget.

Biden And Yellen Left The Cupboard Bare For Trump

Recall, the federal government fiscal year starts on October 1st. After the November 4th election, the Biden administration set about, deliberately and knowingly, spending as much of the full-year appropriation as they could, effectively leaving the cupboard bare for the incoming administration.
 

Indeed, in an interview the Friday evening before Trump was sworn in, then-Treasury Secretary Janet Yellen proudly proclaimed that the U.S. would hit the debt ceiling on Tuesday, Trump’s first full day in office. Is “proudly” an exaggeration? I heard not a tinge of regret.
 

Without a debt ceiling increase, the government is legally prohibited from raising more money. This year to date, there has been no new net debt issuance; all the Treasury auctions have been limited to replacing funds from maturing Treasurys. Bessent is using all the normal accounting tricks and devices, juggling to pay the government’s bills while staying within the debt ceiling requirement.

Lifting The Debt Ceiling Does Not Solve The Problem

But even when the debt ceiling is lifted, there remains the question of who will buy all the bonds, and at what price.
 

Trump has set a deadline for the ceiling to be lifted of July 4th. I doubt this deadline will be met, but assuming the ceiling is lifted (or increased), the later in the fiscal year this occurs, then the shorter the period available to raise funds before the next fiscal year begins. There will be a significant “catch-up” problem.
 

Assuming the debt ceiling is raised in August, the Treasury will need to issue about $1.5 trillion, which is about 66% more than in the same period last year.

Traditional Bond Buyers Not Stepping Up

Thus, the supply of Treasurys over a given period will be higher than normal at the same time that buyers are scarce. It is well known that fewer of the traditional buyers of long-term Treasurys will be stepping up, not willingly at any rate. The large foreign holders –– Japan and China –- are not buyers, and indeed are net sellers. A declining dollar plus the threat of tariffs will not likely cause more countries to be more eager buyers.
 

Moody’s recent downgrade of the U.S. credit rating, the last of the major rating agencies to do so, doesn’t help. Many foreign institutions have restrictions on bond holdings not rated Triple A. Hong Kong’s pension fund managers are limited to 10% of their assets in assets not so rated, and may be required to sell. They have been a sizeable source of buying; remember the Hong Kong dollar is tied to the U.S. dollar, so this is a natural place for Hong Kong institutions to park money.

U.S. regional banks are reluctant to buy because of the whole mark-to-market issue that caused Silicon Valley Bank and others to fail a couple of years ago. The Social Security Fund has been drawing down, rather than buying more. The Federal Reserve, which had been the largest buyer of Treasury bonds, has been a seller in recent years after it instituted Quantitative Tightening three years ago. (Hold that thought.)

So, other than entities with long-date liabilities, such as pension funds and insurance companies, and bond mutual funds, about the only buyers of long-dated Treasurys are hedge funds, betting on a near-term rate reduction that would make their bonds more profitable for a quick trade. They are very price sensitive buyers.
 

Of course, when the debt ceiling is raised, most of the issuance will continue to be at the shorter end of the curve. There is still plenty of demand for 4.5% on less-than-two-year Treasurys; there are few places to get higher yields with relative safety.

A Missed Opportunity

I have said before that it was negligent for the Treasury not to issue long-dated and even ultra long-dated Treasurys in those years when the Fed Funds rate was zero lower-bound, and a majority of government bonds around the world actually had negative yields.
 

If Italy, Mexico and Argentina could issue 50- and 100-years bonds with coupons less than 8%, what rate would the U.S. have had to pay? The U.K. issued 50-year bonds in 2005 with a coupon of 1-5/8% while Austria’s second century bond issued in 2020 had a coupon of just 0.85%.
 

During the Obama years, 2009 to 2015, U.S. rates were at their lowest in history. The 10-year yielded less than 1.5% but that was still higher than most rates of other developed countries. Successive Treasury secretaries, the clueless Timothy Geithner and the underwhelming Jack Lew, preferred to save maybe a percentage point or two by issuing most of the debt at the short end –– and that preference continued through successive presidencies.
 

Imagine how much better the state of U.S. federal finances would be today had those two taken advantage of the historic opportunity and re-financed the U.S. debt at 50- and 100-year bonds.
 

But that opportunity has passed, and yields even on short-term debt are meaningfully higher. Equally importantly, without a steeper yield curve, there is little reason for most investors to buy 30-year bonds as opposed to, say, one-year bills.

Willing And Reluctant Buyers

So the question remains: Who will buy all those bonds when the debt ceiling is lifted?
 

It will come from a variety of sources, including some buyers dragged to trough. The large banks are faced with a carrot-and-stick approach over the SLR. They are being told that they do not need to place so much money in reserves on deposit at the Fed –- oh, and by the way, we won’t be paying interest on reserves any longer (reverting to the long-term practice before the 2008 financial crisis) –– “but we’d like you to buy some Treasury bonds at auction instead.”
 

This could total about $250 billion, but not all at once (though J.P. Morgan’s Jamie Dimon has said that he does not expect his bank to increase Treasury purchases). Wells Fargo has been absolved of its financial crisis sins…“but maybe you could buy some Treasurys.” This could be another $50 billion, if all of the released funds go into Treasurys. Banks generally would favor the short end, anyway, given the Silicon Valley experience.
 

The so-called Genius Act encourages the issuance of “stablecoins” fully backed by U.S. Treasurys, creating new demand. Perhaps some countries, such as the U.K., will step up to the wicket (or the plate) as a quid pro quo for the trade deal. And so on. These amounts are less certain.

QE Is Coming Back

But all these buyers are little more than scraps relative to the total issuance, for this year at any rate, until the whole Mar-a-Largo “bonds-for-defense” scheme can be implemented. Until then, Bessent will cobble together willing and less-than-willing buyers, but three things are clear.

•     Most issuance will be at the short end, where there are more willing buyers.
 

•     Yields on longer-date bonds (already at 19-year highs for the 30-year) will have to go up to attract buyers.
 

•     The Federal Reserve will go back to QE.

As we mentioned, for the past three years, the Fed has reduced its bloated balance sheet in a program of Quantitative Tightening, but this year, that program has been reduced, from $35 billion a month, to $25 billion a month, to just $5 billion a month — a rounding error for a balance sheet of almost $7 trillion.

QT is effectively ended, and once the Treasury resumes issuing new bonds, there is little doubt that the Fed will resume QE, creating credit to mop up the Treasurys. (When President Trump said “if the Fed would lower rates, we would buy debt for a lot less,” given the government does not buy debt, was this a Freudian slip?)

A resumption of QE would be likely bullish for stocks, negative for the dollar, and wildly bullish for gold.

Note: Adrian Day’s Global Analyst is a weekly letter on global markets. We have a special 50% discount for new one-year subscriptions, just $250 for the first year).

Use the code GOLDEN to take advantage of this special offer at AdrianDayGlobalAnalyst.com, GlobalAnalyst@AdrianDay.com or call 410-224-8885.

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