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Three Colliding Macro Trends

It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).

Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.

But let’s get back to what I’d intended to talk about.

Here are three big picture trends that are tying together in my mind in a way that bothers me:

  • Large, and increasing (again), federal deficits
  • An accelerating trend towards onshoring production to the US
  • The Federal Reserve continuing to reduce its balance sheet.

You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.

This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.

Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:

The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).

So here’s the problem.

The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.

And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.

I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…

There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.

None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.

One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.

  1. Andy Fately
    August 2, 2023 at 6:05 pm

    While I think the points you highlight are spot on, my observation of the way things have worked over the past 15 years is that we cannot discount the creativity in how the Fed will address the situation. Personally, I suspect that we will see regulatory changes that force banks and insurers to own larger proportions of debt in their investment portfolios which will be seen as a ‘costless’ way to fill the gap. As well, I believe we are still a long way from the US achieving any soft of balanced trade account, especially in the near term if the US economy continues to outperform those elsewhere in the world, notably China’s. every time I think that the conditions are ripe for something to break, the Fed has been quick to the trigger. I suspect the problems you highlight will simply take a very long time to play out.

  2. Philippe
    August 2, 2023 at 6:14 pm

    Thanks, very interesting reading. The same thing keeps coming back to my mind, and it is in no way motivated by any philosophical/political views – taxes. To the eye of a non-expert, taxes seem like a possible tool against inflation. More taxes would help with deficits too. And I agree that government spending is very likely to continue and possibly increase. On-shoring is a strong motivation to subsidise some of the costs. Energy transition too. And that one is only starting.

  3. Yuki
    August 2, 2023 at 6:17 pm

    “In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers.”

    This is simply wrong. How can one continue to compare a sovereign that can print with a household that is constrained by a budget. This is *not* how things work.

    We can argue about who should supervise this, so that the amount of money doesn’t blow out to some multiple of the actual economy, but we cannot argue about how government spending happens. They don’t NEED money first, in order to spend money. Period. Fini.

    • August 3, 2023 at 8:17 am

      Unfortunately, that’s simply incorrect. They do need to have dollars, if they are going to send them to vendors for goods and services. Whether they get those dollars from taxing, or from borrowing, or from printing them, they DO have to have something in the bank to send. I’m sorry, that’s financial plumbing and it’s the way it works.

      Now, if your point is that in principle, the government can just fire up the printing presses and print dollars, which they then put into the bank – yes, of course that is absolutely true. However, in our system the way that works IN PRACTICE is that the government borrows and spends, and then the Fed buys the debt with newly-created money. That’s why the change in the Fed balance sheet is in the first chart. The Fed is a “domestic saver” in this system. But you’re right, that’s not the same as an individual saving money. AND, further possibly to your point, if household savers aren’t willing to buy enough of the debt at interest rates that are tolerable, the Fed might indeed be FORCED to buy those bonds and reverse the recent tightening / balance shrinking plan. That is one way out (albeit a very inflationary way).

  4. Kevin
    August 2, 2023 at 7:56 pm

    Thanks for your insight as always. When do you think QT would start to have a negative impact on the stock market? I remember back in 2018 when Fed was tightening and reducing balance sheet, the stock market went down 20% or so. But so far the market seems to be immune to the effects of QT.

    • August 3, 2023 at 8:20 am

      That’s a great question and I do not have a great answer. I think I could come up with some quantitative reasoning, but these are fundamentally nonlinear things tied to investor behavior. From a quantitative standpoint, I would think the answer is that there is still plenty of liquidity – but now that some amount of that is drained off for bank HQLA and other collateral requirements it’s hard to know what the system needs. I do think that higher interest rates will tend to move that slowly-diminishing liquidity more into bonds from stocks, so those two parts of the tightening cycle work together in that way. The result might be gradual but also might be quite sudden. Just hard to know.

  5. Mike Myers
    August 2, 2023 at 8:11 pm

    Onshoring will be interesting. Chinese have been aggressive in purchasing American businesses and not only on the stock exchanges. I’m thinking those Chinese businesses will enjoy access to lower cost material inputs than their American competitors who are trying to make everything for themselves. And if there’s a supply constraint in the chain guess who’s going to be first in line for deliveries from China?

  1. September 13, 2023 at 9:57 am

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