by Chris Black
For the Fed to bring inflation down to 2%, it will take the destruction of a significant amount of wealth – something which an unprecedented pace of aggressive rate hikes has so far failed to do.
To the Fed, losing control over price stability is unacceptable (t.me/marketfeed/417246).
BlackRock revealed in their 2023 Outlook that “only a deep recession can effectively decouple the global economy from the risks of persistent inflation.”
The Fed continues to believe in the Phillips Curve, which plots unemployment as inversely related to inflation.
A meaningful decline in inflation cannot be achieved without a correspondingly meaningful rise in unemployment, i.e. a recession.
The Fed must and therefore will engineer The Mother of All Pain Trades, wreaking havoc on an estimated $5.3 trillion in private debt eligible to be refinanced by 2025.
We can clearly see the sequence of events as the path the Fed will most likely take over the next one-to-three years towards the inevitable recession.
I estimate that the recession will arrive in the second half of 2025 or 2026.
UBS: Why hasn’t the US experienced a recession? 10 reasons.
“The likelihood of a recession hinges most on monetary policy getting more restrictive and eventually causing consumer spending to fall. That may take at least (one) more Fed rate hike, but there is also the possibility that monetary policy is operating with an extended lag this cycle (t.me/marketfeed/395362), and the tightening thus far will be sufficient to cause spending to crack (but has yet to be observed).”
“The other plausible recession channel is that credit conditions continue to tighten, which would weigh most on small businesses. Since they account for most of the excess demand for labor, this scenario could entail a rapid cooling (weakening) of the labor market.”
“We should not expect a standard recession in this unorthodox cycle… The economy may instead experience rolling recessions across different segments… Consequently, if one does occur (which has not started so far), it will be the most anticipated recession in our lifetime.”
Below, we will address a few examples that may explain the recession’s ‘tardiness’, including US corporates taking advantage of higher rates, and the expansionary fiscal policy.
The Fed’s quarterly Z1 (www.federalreserve.gov/releases/z1/) provides a snapshot of the balance sheet composition of American nonfinancial (mostly, non-bank) companies, in terms of financial accounts.
The most recent Z.1 L.103 (www.federalreserve.gov/releases/z1/20230608/z1.pdf), in the second image, shows that the American corporate sector is still an outsized net borrower – heavily reliant on debt and thus vulnerable to higher rates (we’d say it has duration risk), at least in theory…
Monetary theory 101 suggests that higher rates create higher interest payments, squeezing profit margins and slowing the economy.
This theory has been validated since 1970: higher borrowing costs have created higher debt payments, which reduces post-tax corporate profits.
Until today. Corporate net interest payments have instead collapsed as rates go higher and higher.
What is going on here?
SocGen looked at the data and “concluded that a sizeable proportion of huge, fixed rate borrowings during 2020/21 still survive on company balance sheets in variable rate deposits.”
In simple terms, this means that, by and large, companies locked their debt into fixed rates while at zero during 2020/2021, and a lot of that borrowed cash still remains on their balance sheets in the form of variable rate deposits, thus profiting from higher deposit rates!
Companies keep their cash in a money market fund (MMF), who will then park it at the O/N RRP or in short term Treasury bills – whichever option offers a higher yield.
As SocGen put it , “Companies have effectively played the yield curve in reverse and become net beneficiaries of higher rates, adding 5% to profits over the last year instead of deducting 10%+ from profits as usual… now the explanation for the delayed recession is far clearer… Interest rates simply aren’t working as they once did.”
Fiscal expansion is simply an increase in real economy spending owing to actions taken by the government. This could include tax cuts but more often refers to the govt running deficits, which is simply the extent to which outlays exceed revenues. Recall that government deficit spending creates private sector money, and so is stimulatory.
Last week, the Treasury announced (home.treasury.gov/news/press-releases/jy1662) a revision to their third quarter (July – Sept) borrowing estimates, adjusted to $1.007 trillion.
Including estimates (home.treasury.gov/system/files/136/SourcesUsesJul2023.pdf) for fourth quarter (Oct-Dec) borrowing of $852 billion, this equates to almost $1.9 trillion borrowed in H2.
According to Goldman, the main cause of the deficit is income tax receipts trailing $442bn below a year ago, which far surpasses the sharp decline during the early days of the pandemic when the unemployment rate rose to nearly 15%.
If one looks at the deficit figures from CBO, then it looks as though the fiscal situation should be little-changed between fiscal years 2022 and 2024.
However, that artificial stability is mostly an artifact of the peculiar way CBO is mandated to account for the White House’s student debt forgiveness plan (www.cbo.gov/system/files/2022-09/58494-Student-Loans.pdf) and the subsequent reversal of that plan — neither of which affect current taxes or spending.
Excluding these largely meaningless swings, the deficit looks like it is set to almost double from $950bn in FY22 to $1.839tr in the current fiscal year! (Fiscal years run from Oct 1 through Sept 30)
JP Morgan writes that “this widening (of the deficit) should partly reverse as we move into FY24, when we project a deficit around $1.6tn” at which point what was a tailwind will become a headwind, because it will represent a decline in what is already a massive stimulus.
But, more importantly, “this year’s ‘stealth stimulus’ may help explain the economy’s resilience to rapid interest rate hikes.”
It is tough to get recession with unemployment at 3% & budget deficit at 9% GDP.
So long as this is the case, the Fed will be unable to induce an inflation-snapping recession.
The Treasury’s new buyback program will have a humble beginning, but tremendous potential to become an essential tool with far reaching impact.
Treasury first hinted at a buyback program (fedguy.com/the-marginal-buyer/) last August amidst concerns over poor Treasury market liquidity and finally decided to launch it next year.
The most recent details (home.treasury.gov/system/files/221/TreasurySupplementalQRQ32023.pdf) indicate modest buyback amounts to both improve Treasury market liquidity and help the U.S. better manage its cash holdings.
The Treasury has explicitly dismissed any intention to use the program to alter it’s debt maturity profile (home.treasury.gov/system/files/221/TreasurySupplementalQRQ22023.pdf), so the program should not have asset price implications.
However, the infrastructure being set up could evolve to allow Treasury a greater role in monetary policy.
Buyback programs are simply the purchase of previously issued debt and are not uncommon among sovereigns.
A number of OECD countries have active buyback programs for the same purposes as those stated by the Treasury.
In fact, the Treasury engaged in buybacks in 2000 (papers.ssrn.com/sol3/papers.cfm?abstract_id=1022669) when it used fiscal surpluses to retire higher yielding debt and save the taxpayer some interest expense.
The innovation today is the establishment of a standing buyback program that would be actively used throughout the year.
Although some aspects are not yet fully determined, the Treasury has shared its conceptual view of how the program would be implemented.
Treasury plans to issue a bit more debt at each auction with the understanding a portion of the proceeds would be used to purchase old debt. In effect, the composition of Treasuries outstanding would be tilted towards the more liquid new issues.
Treasury anticipates that it will announce expected buyback amounts in advance each quarter when it is also announcing new issue sizes.
Although not explicit, Treasury appears to anticipate implementing buybacks through reverse auctions similar to how QE was conducted. In that case, primary dealers would put in an offer to sell a security and Treasury would decide whether or not to accept the offer based on certain metrics.
Treasury noted that it is still in the process of developing the specific metrics.
The buyback program is aimed to both improve liquidity in the Treasury market and to help the Treasury more effectively manage its cash balance.
Treasury’s cash balance can fluctuate due to unanticipated expenditures or seasonal tax flows.
For example, Treasury’s cash balance swelled in 2022 as the tremendous bull market in 2021 led to a surge in capital gains tax receipts.
The Treasury had more cash than it needed and could only get rid of it by passively paying down Treasury bills over the coming months.
A buyback program would have allowed Treasury to instead actively deploy that cash and buyback existing debt and save on interest expense sooner.
Treasury anticipates that cash management buybacks would mostly be deployed around quarterly tax payment dates.
The more important use case for buybacks is to improve Treasury market liquidity.
While Treasury securities are overall very liquid, each specific Treasury security becomes much less liquid over time.
A buyback program would improve it by “cleaning up” illiquid off the runs and replacing them with much more liquid on the runs.
The buyback program appears modest, but meaningfully expands the Treasury’s toolkit by allowing it to both add and remove duration into the market.
Previously, only the Fed took duration out of the market via QE and only the Treasury added duration through its choice of debt issuance.
While Treasury has stated that it would not modify the maturity profile of its debt with buybacks, the program gives it the capability to do so.
The buyback program will start its first year with only a maximum of $120b in liquidity buybacks and a maximum of $120b in cash management buybacks.
It is hard to see $120b in annual purchases having a meaningful impact on Treasury market liquidity, which averages around $600b a day (www.finra.org/finra-data/browse-catalog/about-treasury/daily-data).
However, this is very likely just the beginning. The Fed’s RRP Facility began with counterparty limits of $0.5b (www.federalreserve.gov/econres/notes/feds-notes/overnight-reverse-repurchase-operations-and-uncertainty-in-the-repo-market-20171019.html) that over time expanded to $160b per counterparty (www.newyorkfed.org/markets/rrp_faq) as market needs evolved and comfort with the facility grew.
In the future the buyback program will almost certainly become much larger. Treasury market dislocations like those seen in March 2020 could potentially be solved by Treasury instead of the Fed.
And maybe the program could one day be deployed to influence monetary conditions. For example, Treasury could effectively ease financial conditions by issuing short dated debt to purchase longer dated debt.
There is no indication of this today, but treasuries and the central banks do not always have the same goal and conflicts between the two are common in history (www.federalreservehistory.org/essays/treasury-fed-accord).
The fusion between Treasury and Fed policy, which took off to the races in 2020 (www.federalreserve.gov/newsevents/pressreleases/files/monetary20200323b1.pdf), is ready to make its next historical leap into a deeper and immutable link.
Remember, the New York Fed is a private entity of multinational member banks (www.federalreserve.gov/aboutthefed/files/newyorkfinstmt2022.pdf).
See BlackRock’s August 2019 white paper Going Direct (www.blackrock.com/corporate/literature/whitepaper/bii-macro-perspectives-august-2019.pdf) for the outline.
FYI, Trump says he will replace Fed’s Powell if elected in 2024.
In 2019, Trump threatened to fire Powell over rate hikes (www.theguardian.com/business/2019/jun/18/trump-jerome-powell-federal-reserve-interest-rates) and even suggested dropping interest rates to below zero (archive.is/iKYaf), something which the Fed has not and should not try (www.stlouisfed.org/on-the-economy/2019/december/primer-negative-interest-rates).