THE FED AND US DEBT

The US Government’s fiscal stimulus to combat Covid19 is causing the third significant rise in US sovereign debt in 12 years, following the substantial increases after the Great Financial Crisis (GFC) and to finance Trump’s 2018-19 tax cuts. This note looks at how that debt is likely to increase in the near future, estimating the size of Bills and Bonds that the US Treasury will issue, and questions the source of the demand for that debt. This will allow for a clearer understanding of the future direction of real yields and swap spreads, which is one of the keys to valuing private sector asset prices.

CURRENT AND FUTURE OUTSTANDING DEBT

For the purpose of this note, “Bills” refers to zero coupon Bills and CMB’s with short term (less than 1 year) maturities issued by the US Treasury, whilst “Bonds” refers to 2-10y Notes, 30y Bonds, 10 and 30y Tips and FRNs that all pay coupons that are issued by the US Treasury.

Given the US Treasury’s (UST) $1.8trn debt issue to date, plus their recent announcement of probable Bond issuance over then next 6 months, and known redemption profiles of maturing bonds, its fair to assume that the total NET increase in debt for the whole of 2020 will be at least ~$3trn (some expect up to $4trn due to even more fiscal stimulus), taking outstanding debt to ~$20trn by year end 2020. This increase in debt is double the annual increase during the GFC and is similar to the total outstanding stock in 2001!

But what about future debt increases beyond 2020? Whilst there is a healthy debate about the shape of GDP recovery, GDP does not determine debt trends, budget deficits do. Chart below shows the US unemployment rate, GDP growth and annual budget deficit for the last 20 years with the three periods of substantial debt increases. Compare the “V shaped” GDP recovery against only the “swoosh” recovery of the deficit.

The deficit swoosh aligns to the top right chart of the large annual debt increases between 2008 to 2012, which is a good indication about the likely trajectory of US debt stock in the next few years. Considering the GFC experience of only a gradual improvement in the deficit over time (due to cyclical stabilisers), it would not be unreasonable to expect similar debt increases over the next three years given the seriousness of the current slowdowns of the service and manufacturing sectors. Assuming no meaningful tax increases or serious cuts in government expenditures in the near future, the market should be expecting debt increases of at least $2trn to $3trn a year for the next 2 years.

Making the debt financing dynamics more complicated is that debt had already risen by more than $1trn a year in the two years before Covid struck, due to the Trump “tax give away” deficits. This rise in debt stressed financial markets in 4Q18, when rising yields coincided with a heavy equity/corporate bond sell off, necessitating Powell to do a complete U-Turn and move the Fed from tight to loose monetary policy, despite good GDP growth.

TRENDS OF DEBT INSTRUMENT ISSUANCE

How did the US Treasury raise ~$1.4trn in the month of April, a sum that was almost 3 times the emergency $495bn raised in Oct08? Emergency cash can only be raised in such size through the issuance of Bills with short expiries (Cash Management Bills - CMBs) which draws short term temporary investments (i.e. cash) from the private sector. In April the Treasury increased outstanding Bills by $1.358trn and Bonds by a mere $14bn. This is similar to the UST’s actions in 2008. Huge issuance of Bills immediately shortens the average maturity of the outstanding debt stock and opens the UST to refinancing risk when the bills mature. Chart below shows the impact on the average life of outstanding debt when the UST issued ~$500bn in Oct08.

To rectify this, the UST has already announced that it will start increasing the auction sizes of longer maturity Bonds to “term out” the debt and thus extend the average life of the outstanding stock. This is similar to what the UST did from 2009 to 2016, resulting in a gradual rise higher in the average life of the outstanding debt.

The chart below shows the MONTHLY increases in NET Bill and NET Bond issuance over the last 20 years (data is the 2mth moving average to smooth the lines). Note the increase in Net Bill issuance (right axis) in 2008 to raise cash immediately, followed by the subsequent increase in NET Bond issuance. The effect of the 2018-19 Trump “tax give away” is plainly evident through observing the gradual increase in Bond issuance from 2018. The most recent Bill issuance for Covid19 sticks out, as does the forthcoming increase in announced NET Bond issuance (US Treasury Qtly Refunding statement).

Again, note the elevated Bond supply in the years after the GFC, and the already elevated levels pre Covid. The market should expect a rise in Bond issuance to a minimum of $150bn a month AND for that monthly Bond supply to remain at or above those levels for an extended period of time. This raises the question of who will buy that increased issuance of longer dated Bonds?

POTENTIAL DEMAND FOR THE INCREASED BOND ISSUANCE

The Federal Reserve publishes its Balance Sheet every week, detailing its holdings of US Bills and Bonds, whilst the US Treasury publishes the major foreign holders of Treasury Securities. Subtracting the Fed’s and Foreigners’ holdings from the total outstanding debt gives the stock held by domestic private institutions (Pension Cos, Lifers, Mutual Funds etc).

The left chart below shows the ANNUAL net increase in US debt (2020 is year to March) and expected full year 2020 and 2021 (black and pink respectively - right axis). The columns show who has bought what proportion of that annual supply (adding up to 100% - left axis). The right hand chart is the same, but shows the $ amounts of purchases by the fed, Foreigners and Domestics. In both cases, the 2020 columns represent purchases to the end of March. Note that the FED purchased a cash sum equivalent to ~80% of the money raised by the UST so far in 2020. Compare that to 2008 when the Fed was a net seller of USTs - it was only in 2011 that their purchases were a substantial proportion of the issuance.

There are three complications and unknowns with regards to the understanding future Bill and Bond demand:

1. The Fed is NOT buying what the UST is issuing. The UST has been increasing the debt by issuing short term BILLs, but the FED has been buying (longer dated) Bonds. There is therefore a huge duration mismatch between the UST supply and the Fed demand. In normal circumstances, the Fed’s $1.1trn purchase of Bonds in April against a mere $150bn of net supply of Bonds would lead to a substantial decline in Bond yields – and yet yields were roughly unchanged during April (10 year US Treasuries started the month at 0.66% and ended at 0.64%!). This suggests there was very significant selling of Bonds by either Domestics or Foreigners (or both).

2. What will foreigners do in the future? Perhaps a clue can be found in the recently UST published data on foreign holdings, which shows that in March they were net sellers to the tune of $ 257bn, the largest amount in the last 20 years and more than twice the previous largest monthly decline in their holdings (chart below – green)

Did this continue in April? Is this a sign of new behaviour given the trend in global deleveraging and the fiscal difficulties being faced by other countries with Covid19, especially China, EM and petro-economies? Foreigners purchased almost 50% of the huge $6.5trn debt issuance following the GFC (table below) – if they don’t increase their holdings in the future, the Fed will have to make much larger Bond purchases in the future to avoid domestics needing to fund the deficit. Otherwise there will be a significant rise in real rates and an underperformance of government bonds against the interest rate swap curve (“tightening” swap spreads).

3. There is no absolute certainty of the Fed’s exact demand for US debt, just an assumption that it will be high. Year to date the Fed has purchased an equivalent ~80% of the $2.1trn cash amount raised by the UST’s Bill and Bond issuance. The chart below shows how the Fed intervened very heavily in March and April, initially buying a greater amount of Bonds than the sum being issued by the UST (Blue higher than Black), taking the net supply (Red) negative. Since the 9th April, though, the Fed has taken its foot off the pedal with its Bond purchases, and for the month of May to date, its purchases have only been equivalent to 34% of the increase in debt. This means that there is a requirement for private sector and/or foreign cash to finance the net debt issued (red).

REAL YIELDS AND SWAP SPREADS.

In March there was a huge spike in Real Yields (left chart below) whilst government bonds seriously cheapened to the swap curve (right chart below). Both are a clear demonstration of large net selling of US government Bonds, which then stopped and turned around when in mid March the Fed announced that it could buy an “unlimited” amount of government Bonds under its QE program.

Real yields retraced those rises and have subsequently remained very stable across the curve during the late April/early May period of net supply to the market. However whilst Bonds also regained their underperformance to the swaps curve, in the last 6 weeks they have started underperforming the swaps curve again (pink arrows right). This is a clear sign that demand does not currently equal supply at current valuations.

CONCLUSION : THE FED'S ROLE IN FUNDING THE NEXT FEW YEARS' DEBT INCREASE WILL BE CRUCIAL FOR PRIVATE SECTOR VALUATIONS.

There will be a vast increase in debt over the next two years necessitating a large increase in Bonds. It will be key to monitor the large net supply of Bonds against the Fed’s weekly balance sheet, and observe the concurrent direction of real yields and swap spreads. This will give a very strong indication of foreign and domestic demand for the net supply as well as any changes to the net stock of foreign and domestic debt.

For the time being the Fed is following a debt interventionist policy and despite their announcements to the contrary, there is enough clear evidence this is debt monetisation and the US is indeed in a debt trap. The base case going forward, considering the Fed’s behaviour over the last 12 years, should be that they will buy a substantial proportion of the US Treasury debt increase. Indeed the market should be expecting the Fed to substantially expand its balance sheet in the near future. The Fed currently holds $4trn of US government debt – it’s not difficult to see that swell by another $4trn over the next 3 years.

Any future deterioration (tightening) of swap spreads or any rise in real yields would suggest that the Fed is not counterbalancing weak demand for new net debt. This would be a huge warning flag for investors in private sector risk assets for it would be a clear indication that the Fed is requiring domestic private investors to divert their savings from private sector assets to fund the deficit, which would mean a revaluation lower in risk asset prices.

Holders of government bonds and risk assets are thus likely to be reliant on a huge expansion of the Fed’s balance sheet in the future, taking it to double its current size in the next years.