Hey There Income Hunter,
Let me be frank …
It will be extremely hard for the Federal Reserve to avoid a government debt crisis.
That will become obvious by the end of next year, but you heard it here first.
Here’s what that means …
Because of the impossible situation the Fed and government finds themselves in – high inflation, very low economic growth, and high debt-to-GDP …
They will be forced to ultimately choose which one to rescue, and without a doubt the Fed’s most critical mandate is to give the public the impression that the government is solvent.
Higher bond rates, due to inflation, make it hard for the Fed to stabilize (or even keep its 130% debt to GDP from rising further) …
All it can do is kick the can down the road as long as possible before admitting it needs to print new money in order to pay back its debt.
Today, I will reveal all the ways the Fed can punt …
And what these programs mean for the markets.
Treasuries > Equities
The US Treasury securities market is 10x more important to the Fed than equities for two reasons:
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The bond market accounts for roughly $300 TRILLION, far surpassing the equity markets. Plus corporations and the government rely on it for the majority of their borrowing needs.
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The bond market funds government spending, so a broken bond market creates a fiscal nightmare for the government, meaning it could reduce their ability to spend.
The problem today is the UST market has lost liquidity and added tremendous volatility, which is a bad combination. Let’s take a look.
Notice the two charts side-by-side below …
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On the left is the liquidity index. Because of the imbalance of supply to demand, we are seeing extreme levels of illiquidity.
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On the right, a volatility index similar to the calculations used for the VIX and is at a historical extreme of volatility.
These are the critical signposts showing that the US government bond market is the one that will ultimately break the financial system and force the Fed to go back to QE and printing money – regardless of inflation.
Kicking the Can
The Fed is creative at letting the markets think it is doing one thing while actually doing something else behind the scenes.
So, the way the central bank will kick the can down the road is by continuing to fight inflation – while behind the scenes deploying various programs to stimulate the markets at the same time.
Now, we may be hearing more from Janet Yellen in the weeks ahead as she and Jerome Powell join forces in an effort to avoid reality for as long as possible..
Fed Liquidity Programs
Reverse Repo: Reverse repo is a program the Fed instated during Covid so it can build a nest egg of liquidity. This was accomplished by offering a higher interest rate than available in the shortest maturities of government debt to about 100 money market funds.
It is simply a collateralized loan that money market funds execute with the Fed. They currently earn about 3% after the Fed hiked .75% on Wednesday. When needed, the Fed can reduce the rate on reverse repo, forcing money funds to close their loans and invest directly into the Treasury market.
Notice the reverse repo facility below showing an initial turn lower from a peak of over $2.3 trillion in balances held at the Fed. A decrease in these balances is an important signal that funds are being injected back in the bond market.
Operation Twist: This the selling of short-dated bonds, which are heavily in demand, to buy longer-dated bonds, which are less liquid and riskier.
You will hear from the Fed that Operation Twist has no impact on the size of government debt …
That is true based on dollars borrowed, but the program sells short-term bonds, which have little-to-no risk, to buy long-term bonds which have enormous risk.
So, in reality, OT is highly inflationary because the Fed is removing an enormous amount of risk from the bond market, which is very bullish for mortgages and housing and even mega cap growth tech stocks. More details on OT can be found here. More details on OT can be found here.
Bank Capital Relief: This would be accomplished by the Fed providing an exemption for US banks from having to include US Treasury bonds as an asset on their balance sheet.
Under the supplementary leverage ratio, banks must hold a capital buffer against all assets on their balance sheet … If they are able to remove Treasuries, that would allow them to provide much more liquidity in the bond market.
Read The Fed’s Next Step for more on the SLR exemption.
Treasury Buyback Program: This would be similar to the yield curve control program that the US government used in the 1940s and Japan and the UK are using today …
This would also be similar to Operation Twist, but would be the most inflationary program the US could enact because the Fed would print new money so the Treasury could “monetize the debt” by buying bonds from banks to cap interest rates (ala Japan).
This would signal that the US is entrenched in a sovereign debt crisis.
Exemption for Banks to Hold Capital Against USTs May be First Step
I think a Fed exemption for USTs from the supplementary leverage ratio (SLR) may be the first change introduced.
On Oct. 27, Janet Yellen said, “Any change to the Treasury supplementary ratio is a matter for Banking regulators to decide.”
The Fed is the regulator for bank holding companies and it instilled the exemption from April 2020-April 2021, so this is a logical first step.
My thinking is that the comment from Yellen above means she is not actually leaving it up to banking regulators – she wants it done.
Bring It Home
The bottom line here is, If you see any credible announcements that these programs will be instituted, buy bonds, gold, bitcoin and/or commodities.
By injecting new money into the markets and the economy, all these programs will be inflationary.
My suspicion is we will see them rolled out in various shapes and sizes in Q2 2023, but it could be even sooner than that ..
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Live and Trade With passion My Friend,
Griff