Hey There Income Hunter,
It is crunch time in the inflation/recession battle.
The signpost to pay close attention to is the difference between the interest expense the US pays on its Treasury bond debt and US tax receipts.
It’s the Ohio State-Michigan of economic data.
Currently, the net of the two on an annual basis is a negative $800 billion, but it is starting to widen, which means the Treasury will have to issue more bonds to pay for the growing gap.
This scenario is an indication the US may be entering the vicious cycle of a slowing economy, higher inflation and higher interest rates.
In yesterday’s letter, I discussed a Fed report in which the central bank finally admitted that it is unable to engineer a soft landing.
Well, uh, duh.
I’ve been preaching that for the past year.
Now that it is finally out in the open we can be certain of the path Powell will take …
Today, I’ll illustrate why it is an either/or decision and what Powell is most likely to do …
Up until last week, the Fed had been willing to admit that it would be impossible to accomplish what Paul Volker did in the seventies – namel to to raise rates as high as needed to stop inflation.
Powell does not have the luxury, because with a $30 trillion debt burden raising rates much above 3.5% would drive up the cost of capital for ALL other borrowers ….
The reason it would affect all borrowers is because, as the global currency, there is a massive US dollar lending and borrowing network outside the US known as the Eurodollar market. It’s the place where non-US companies lend and borrow dollars from one another …
However, as the dollar rises against the local currencies of all these counterparts, their debt becomes more expensive versus their income derived in their local currency.
The Dollar Wrecking Ball
The dollar is strengthening due to the aggressive rate hiking policy of the Fed.
Inflation forces the Fed to raise rates and foreigners are incented to swap their local currency for dollars in the foreign exchange (FX) market and then invest in dollars to improve their returns.
The higher rates in the US can cause big problems, as well, since higher rates means all borrowers pay a higher cost for borrowing or refinancing loans.
This also pertains to the government, whose balance of payments is no different than any corporation.
See, what most commentators fail to realize is that the process of killing poorly managed companies can be a good thing. However, the Fed’s hawkish stance will drive tax receipts down and interest on government debt above the tax receipts
That is the recipe for disaster because pushing rates above inflation (Fed speak on their plans) with debt/GDP above 100% is not a mathematically or economically sustainable option.
The Balance of Payments Vortex
The chart below illustrates the vicious cycle of spending and deficits followed by printing more currency to issue debt and borrow.
This goes on until your debt has “crowded out” investors, which drives interest rates higher …
Which then slows economies and lowers tax receipts ….
Understanding this cycle helps you understand why countries who are the sole reserve currency of the world have an expiration date.
That date begins when government debt rises to 100%+ over GDP and the home country does not have a highly productive economy able to support the debt. (Sounds familiar!)
Another way to look at what drives the balance of payment cycle is to see the impact that higher interest rates have on the interest expense a government must pay investors on ballooning debt.
US 10-year Rates vs Interest Expense on US Government Debt
The most challenging situation the US and western central banks face is higher interest rates during a recession ….
For companies and countries, making less while paying more is bad enough, but then to have higher interest rates on your debt to pay causes tremendous financial stress.
Notice the Fed graph below, especially during 2018. That was the last time the Fed was doing QT, raising rates and the debt was high.
Interest costs rose 10% in one year!
So, today that would be 10% of an $800 billion deficit – or an increase of $80 billion.
Then the Treasury must issue another $80 billlion in debt when investors do not want to buy bonds, especially in a high inflation environment, which drives interest rates higher, and so on …
Bring It Home
Now, I have also been talking about Powell’s legacy recently. This will be his last stint at the Fed and all he really cares about is the legacy he leaves behind.
The only way he can save face now is to double down on the hawkish policy until the system risk shows up in a sector of the economy and he can pivot back to QE and be the savior.
He performed that role in 2018 and he will do it again in the months ahead.
The blueprint for trading at this point is clear: Have a core short in the indices while SPX is below 4000, and watch the credit spreads and interest rates for signs of building systemic risk.
If the market continues down over the next week-and-a-half, the ideal time to begin positioning for a Fed pause/pivot, I believe, may be the week between the Sept. 16 options expiration and the Sept. 21 Fed FOMC meeting.
Questions or comments? Drop them below or shoot me an email.
Good luck and as always …
Live and Trade With Passion My Friend,
Griff