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Special Commentary By Steve Blumenhal |
The U.S. deficit has been going up, and it’s been going up because of higher interest rates. $17 trillion of treasury bonds come due in the next three to six months. The average interest rate on them is well below where interest rates are today. A lot of them are at 50 basis points. And if you have to reinvest them at 4% – you got an arithmetic problem.”
Jeffrey Gundlach, DoubleLine Capital
While Nvidia stole the show , Wednesday’s Treasury auction of 20-year Treasury bond notes was the worst on record, leading to a broad-based selloff in government debt. Why did it happen? And why does it matter?
When the government needs to borrow money, they sell bonds to investors—you, me, institutions. You can also think of these investors as lenders. The government sells these bonds by holding auctions, where they indicate the specific amount of money that they want to borrow at a specific interest rate. Investors can say “yes” and put in a bid to buy the bonds at that rate, or they can pass.
Investors can also offer to lend money to the government at a higher interest rate than what the government proposed. Say the government says, “We’re willing to offer a 4.50% yield on the 20-year Treasury bond we’re selling at this auction.” Some parties at the auction will accept that rate while others may counteroffer, saying, “I won’t buy that yield, but I’ll buy a 4.59% yield.” At Wednesday’s auction, 4.44% was the low-yield bid, and 4.595% was the high bid. The government will start with the investors who accept their proposed interest rate. If they can’t borrow the full amount they need from investors willing to buy at that rate, they move on to the investors wanting to buy at a higher yield. At the end of the auction, everyone gets the same yield—the yield at the highest accepted bid, or in this week’s case, 4.595%. The difference between the proposed yield and the final, accepted yield at is called a spread. The larger the spread, the worse the auction is deemed to have gone. Why? A large spread signals weak demand, lack of faith in the government’s fiscal situation, lack of liquidity in the financial system, etc. While there have been large spreads at other auctions recently, Wednesday’s spread broke the record for a 20-year Treasury bond auction. The media called it “ugly.” When we talk about the bond vigilantes calling the government to task, we’re talking about this. The government needs to fund itself, and the task is getting more challenging. In conclusion, the government wanted to borrow new money at a lower rate, but investors said, “We’ll only lend you the money at a higher rate. Otherwise, we walk.” The record-high spread required to complete the auction is a sign of mounting troubles in the financial system.
In a picture, it looks like this:
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Source: CBO and @charliebilello
Investor Jeffrey Gundlach points out that the U.S. is running a deficit of over 6% of GDP. And the economy is currently in ok shape. In recessions dating back to 1969, the deficit jumps higher at an average of about 5% of GDP.
The last three recessions got sequentially worse. So now we’re running 6%-plus of GDP, and there’s every reason to believe that in the next recession, the deficit could increase to as much as 12% of GDP.
Well, here’s the real kicker: If we go to 12% of GDP and stay there—which is a big “if”—with interest rates at 6% (guessing on Treasury yields), the interest expense, as a percentage of tax receipts, will go up to 80% of tax receipts. That is an impossible position to be in. It cannot happen. Gundlach added that the one thing that Jay Powell should be thinking about is that maybe we shouldn’t be so dogmatic about the inflation target; maybe we need to worry about the solvency of the entire financial system. The big macro point here is that the debt hole is getting deeper. We must figure it out. It will take great leadership and won’t be easy, but we must figure it out. There is a way out. I just can’t envision an easy way out.
This Isn’t New
If you’ve read Edward Chancellor’s book The Price of Time: The Real Story of Interest, you know that what much of the developed world is currently experiencing is not new. Chancellor delves into the historical evolution of lending and borrowing, examining how central banks’ manipulation of interest rates has influenced economies and societies over centuries. He argues that artificially low-interest rates have led to significant economic distortions, including asset bubbles, excessive debt, and widened inequality.
Through a blend of historical analysis, economic theory, and current examples, Chancellor presents a critical view of monetary policy and its consequences, warning of the potential dangers of continuing on the current path. The book serves as a historical account and a cautionary tale about the power of interest rates and the cost of disregarding their natural, market-driven levels. We can—and should—learn from history.
In the CRE office space market, the defaults, write-downs, and risks within the banking system are likely to ripple through the economy.
The challenges are already impacting small and regional banks and certain real estate investment trusts (REITs). Below, I briefly summarize what Tan Kai Xian of Gavekal Research calls in his recent article, “Day of Reckoning for U.S. Commercial Real Estate,” a “slow-motion train wreck.”
He concludes that the risks in the system are somewhat bifurcated, with small banks and small businesses at greater risk than larger banks and large companies.
Ultimately, this puts pressure on growth in the economy, but it’s not systemic.
Rising interest costs and accelerating government debt are the bigger problems for the economy and risk markets. I must add that very few thought the subprime crisis in 2008 would be systemic. It sparked the Great Financial Crisis. Systemic indeed.
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