Back in December of 2021, I suggested that the era of easy money was over, that the 30-year treasury debt party was coming to an end.
“Will this party ever end? It will, and the first sign of trouble will be increase in the 10-year treasury yield.”
Safe to say that this party is over.
Here is the graph I previously presented suggesting that the yield of the 10-year treasury had bottomed out, and was in fact beginning to increase:
And here is the latest data:
And this is where I utilize my extreme Photoshop skills and overlay the first graph on top of the new one. (The red arrow indicates the original graph.)
Wow. Clearly a dramatic increase in the 10-year treasury yield since then, meaning that the interest rates for all loans have dramatically increased.
Hopefully you have not been investing in long-term debt these last few years.
In “Who Sets Interest Rates?” I explained that it is not the Federal Reserve, but the secondary market for treasury debt that really sets interest rates, and the markets have spoken. Rates increase when the price of the debt instrument decreases, and a drop in price for any financial asset simply tells us that the demand to supply ratio has shifted, that either the demand has dropped, the supply has increased, or both.
While measuring the demand for treasury debt is difficult, what can be safely stated that our federal government has recently been even more fiscally irresponsible than normal, dramatically increasing the supply of treasury debt thanks to a very high level of deficit spending.
How irresponsible have they been? Consider the U.S. federal government 2022 financials, released by the Congressional Budget Office (CBO):
Simple math tells us that in order to balance the books in 2022, the U.S. Treasury had to create and issue an additional $1.4 trillion of debt, knowing that the Federal Reserve would not backstop it. The Fed’s balance sheet clearly shows that as of Q1 2022, per its stated goal to reduce inflation (by reducing the money supply), they were in fact reducing their debt holdings, the opposite of a debt backstop.
2023 total revenues are projected to be $4.8 Trillion, less than 2022, and if one factors inflation, much less in terms of wealth. 2023 total outlays are projected to be $6.2 trillion, also slightly less. Meaning that to finance 2023, the U.S. Treasury will have push another $1.4 trillion of debt into the market.
Which is happening now, thus the excess supply of treasury debt.
Who is going to buy this additional debt? Good question, because unless someone steps forward, this dramatic increase in rates will stick around for a while, promising a widespread and disruptive impact on our economy.
Kind of like a hangover, which is to be expected after a 30-year party. What happens next?
Cuts in Discretionary Spending
In 2022, the interest payment on the debt was $475 billion. While this was just 7.5% of all outlays, it represented 28.5% of the discretionary spending portion (that Congress has control over.). With higher interest rates, it is expected that as the interest payment on the debt increases, there will be less dollars available for discretionary spending. Note the CBO projected drop over the next decade.
Expect even more political tension in Congress as the choice will be either significant spending cuts or a massive tax increase. Or both.
A Reduction in Consumer Spending
The excessive expansion of the money supply during the 30-year party, and especially during the Covid years, created the illusion of wealth. Many had more money to spend (or could borrow more), which led to more spending, a hard habit to break.
Which probably explains why consumer debt is at an all-time high of over $1 trillion, per the following graph:
While a significant input to the GDP measurement is consumer spending, it does not factor in debt enabled spending or how rational the spending is. That would be harder to quantify. Which implies that the GDP reading on the health of our economy can be deceiving.
This record level of existing debt, combined with a higher cost to borrow, will eventually curtail consumer spending. It is just a matter of when.
A Seized Housing Market
The inventory of houses for sale is about ½ of what it was 10 years ago, and prices remain stubbornly high. Why? Because about 82% of homeowners are presently locked into fixed low-interest rate loans, and have no incentive to sell and buy a new home, which could shift them over to a high interest rate loan.
The housing market has seized up. Existing homeowners unwilling to sell, and the younger generation unable to afford the high prices. This may take some time to work out.
This will be a painful transition, reverting back to historical normal interest rates, higher than they have been for the last 30 years. One possible outcome is that in the long run, this could revert us back to a more fiscally responsible government, with a less centralized, more efficient economy.
Or, if interest rates continue to climb, there will no doubt be political pressure on the Federal Reserve to “fix it”, implying even more monetization of debt, a further devaluation of the dollar. Which will not only be very inflationary but will continue to encourage excessive government borrowing.
I sincerely hope this is not the chosen path, as high inflation is a regressive tax, a dead weight on economic efficiency, and a proven source of social unrest.