The bedrock is cracking…

We’ve been talking the past week and a half about the economy, interest rates, and normalization.

Today, let’s delve into the cornerstone of global finance—US Treasuries. Treasuries have been the bedrock of the global financial system in a sense… but the foundation is now cracking.

US Treasuries are government debt securities issued by the United States Treasury Department. They’re considered risk-free assets. And they underpin much of the global financial system. Here’s how they work:

Domestic Role: Treasuries finance the US government’s operations. They’re sold to investors who then receive periodic interest payments at the specified yield for the full duration of the security. Insurance companies, banks, investment funds, and private corporations buy Treasuries to earn a rate of return on their cash reserves.

Global Role: Treasuries have been the world’s reserve currency since the end of World War II. Countries and central banks use them to store value in dollars, settle international transactions, and to manage their own currencies. This allows the US government to borrow money at lower rates and issue financial sanctions with global impact.

Both domestic and foreign institutions have used US Treasuries as a primary reserve asset for over 50 years now. But as we discussed yesterday, every aspect of the economy has been distorted in that time… and the US Treasury market is no different.

Perhaps the biggest culprit was the Federal Reserve’s (the Fed’s) quantitative easing (QE) programs. They were instituted by Fed Chair Ben Bernanke in 2008.

With QE, the Fed began creating new dollars from nothing to buy US Treasuries of various durations. This flooded the market with liquidity… which created second order effects throughout the economy. They are:

Yield Distortion: QE pushed Treasury yields down to nearly zero and kept them there for the better part of 15 years. This inflated bond prices and eliminated the ability for investors to earn a rate of return on their cash.

Savings Disincentive: With interest rates near zero, there was no incentive to save. In fact, saving was a losing proposition due to inflation.

Investment Misallocation: Treasuries yielding next to nothing encouraged rampant speculation as the market had to reach for yield. This caused investors to misallocate capital chasing speculative assets. And this created asset bubbles not tied to real economic growth.

These distortions have set the stage for massive instability in the future. Consider this…

Bank of America owns roughly $600 billion worth of US Treasuries. And the bank bought over 1/3^rd of its Treasury stash in 2020 with the 10-year Treasury yielding less than 0.9%.

Keep in mind that the value of a bond moves inverse to interest rates. When rates go up, bond prices go down. And rates have gone up significantly since 2020. As such, Bank of America is sitting on losses of over $100 billion on its bond portfolio.

Yet, the bank’s total equity is less than $300 billion. And it’s Tier One capital is roughly $200 billion. That means Bank of America could become insolvent if interest rates move much higher. Is it any wonder that Warren Buffet has been dumping Bank of America (BAC) stock like there’s no tomorrow?

This is something to keep an eye on. Bank of America is the largest depository institution in the US. Any dislocations at the bank would be seismic.

Now consider this…

The US government has added $2.1 trillion to the national debt just in the last 100 days. US federal debt is now up to nearly $36 trillion. This largely represents total US Treasuries outstanding.

Current projections show that the US government will have to pay $1.1 trillion in interest on this debt next year. That will be one of the government’s greatest expenses, trailing only Medicare and Social Security.

This simply isn’t sustainable.

Either the US government will need to cut spending and pay down the debt so it’s interest payments don’t spiral out of control… or at some point the world will stop buying US Treasuries. Then the entire dollar-based financial system would collapse.

This is why Fed Chair Jerome Powell continues to talk about “normalization”. It’s also why interest rates are not going to fall that much from here.

More to come…

-Joe Withrow