It’s that time of year when Wall Street strategists offer up forecasts for the year ahead. While I’m going to refrain from prognosticating a specific target for the S&P 500 index, I would like to share some thoughts on what I think makes this moment in time potentially very different from others we have experienced in the past, and the biggest issues investors should be thinking about today.
What recession?
Coming into 2023, it seemed like virtually every pundit was calling for a recession in the US in 2023. There were plenty of reasons for this, as you’ll see. The most obvious was just based on common sense. We had just been through an extraordinarily prolonged period of low interest rates (the lowest in recorded history). This fact, combined with the extraordinary stimulus unleashed in response to COVID (stimmy checks, PPP loans), topped off with the slow response from the Federal Reserve (“it’s transitory”), helped unleash a wave of inflation in both producer and consumer prices unlike any we had seen in the last 40 years.
The price inflation forced the central banks, including the Fed, to start aggressively raising interest rates early in 2022, which continued at the most aggressive pace ever into 2023. Given the incredible buildup of debt that the prolonged period of artificially low rates engendered, why would we not expect raising rates at the fastest pace ever to a policy rate which had not been seen in the US since 2007 to land us in recession? That’s just the way these things have gone for the past several decades…..the Fed raises rates until something breaks in the system, helping bring about an economic recession, then the Fed responds by reversing course and aggressively cutting rates once the recession becomes obvious. The “obvious” part is usually when the labor market cracks.
This common sense view has been strongly supported by some warning signs which have a very impressive track record of telegraphing oncoming recessions. The first of these is the yield curve itself:
Source: St. Louis Fed
Recessions are marked with the vertical gray bars in this chart. As one can see, every time the yield of the 10-year treasury drops below the yield on a 2-year treasury, especially if it does so in a significant way for a prolonged period of time, as has been the case in this cycle (since July 2022 or 17 months), a recession follows. Why is this? Well, think about it. What does it say when a buyer of US treasury debt is willing to buy a longer-term bond and accept a lower yield than by buying a significantly shorter-term obligation? Under normal circumstances, the longer-term bond should offer a higher return because it is much riskier. Ten years is a long time compared to two years – a long time for interest rates to move, resulting in price volatility in the longer-term bond, and a long time for inflation to reduce the real value of the principal value of the bond.
So when investors, collectively, are willing to accept a lower yield on longer-term bonds, they are effectively saying that they believe the Federal Reserve is going to be forced into interest rate cuts in the near future on account of economic weakness, and not only will those short-term yields not last (1-year T-Bills are yielding 5.13% as of this writing), but those longer-term yields (4.28% on the 10-year and 4.36% on the 30-year Bonds as of this writing) are going to look pretty good in the near future.
To be clear, I don’t necessarily agree with that last part, but that’s what the market is trying to say.
The second big data point staring us in the face here is the Conference Board’s Index of Leading Economic Indicators, which has been in decline for 17 consecutive months now:
Source: The Conference Board
Source: The Conference Board
Unfortunately these charts do not show the full history of this indicator, but it is equally impressive in terms of calling recessions. Do we want to bet that somehow it’s different this time? I for one am not willing to do so. I actually suspect that we are already in recession, as evidenced by the fact that Federal tax receipts have been generally declining since 2Q2022, when they peaked at $5.025 trillion.
Source: St. Louis Fed
Although the labor market, officially, has held together OK, the official U-3 Unemployment rate has ticked up from a cycle low of 3.4% to the current reading of 3.7%. Setting aside the arguments as to whether this statistic is accurately measuring weakness in the labor market or not, generally speaking when the unemployment rate rises by 0.5% from its low, a recession is imminent. Labor is generally one of the last dominoes to fall because employers are reluctant to let go of their talent, until they have to out of necessity. Prior to the last print, this U-3 statistic was at 3.9%. My guess is that it will be at 4% by the first quarter, adding another piece of the puzzle to the picture.
Debt and Deficits
The thing that makes the prospect of a recession especially worrisome at this juncture is that it is happening at the same time the US is already facing record budget deficits. These are being driven by a combination of rising Social Security and Medicare costs on account of the retiring baby boomers, and the effect of the highest interest rates we have seen in over fifteen years meeting a record pile of US Government debt:
Source: St. Louis Fed
Source: St. Louis Fed
If you do the math on that – $981 billion in annual interest on $33+ trillion in debt, it works out to around 3% per year. All interest rates on US government debt on my FactSet screen today are over 4.25%. So unless interest rates come down quickly, simple math would dictate that the $981 billion figure is only going to go higher as existing government bonds mature and need to be rolled over at existing rates.
It’s also worth noting the other ratio here – the percentage of government receipts that are being used just to pay interest on the debt. That works out to 20.8% ($981b/$4712b). That’s appalling, and the fact that it has gotten virtually no attention tells you a lot about the state of the American news media.
Hopefully you can begin to see the problem here. In a recession, deficits go up while tax receipts fall and additional social spending kicks in the help alleviate higher unemployment. Higher deficits imply additional issuance of treasury debt, on top of what was already planned, to plug the hole in the budget. Meanwhile, the Federal Reserve, who has been a significant buyer of government debt since the Great Financial Crisis of 2007-2008, is still trying to shrink its balance sheet, removing a prospective buyer from the market and adding additional pressure to the Treasury in their quest to find enough buyers of their debt:
Source: St. Louis Fed
So not only does the Treasury need to issue enough debt to finance the large and growing budget deficit (around $1.7 trillion annually), it also needs to issue enough to replace the bonds which are maturing and held by the Federal Reserve. Since that little spike you see from last March, when the Fed came up with its latest four-letter program to rescue the regional banking system (BTFP/Silicon Valley Bank), their balance sheet has declined by almost exactly $1 trillion in 8 ½ months. That’s approximately $117 billion per month or $1.4 trillion per year, on top of the budget deficit, that the Treasury needs to come up with at its weekly auctions.
Who, exactly, is going to buy all of this debt? It’s an uncomfortable question with no obvious or easy answers to it.
One way in which the Treasury has dealt with this problem this year is by issuing more and more very short-term debt instead of longer-term debt. By increasing its issuance of T-bills instead of Notes and Bonds, it has allowed supply to be absorbed by those looking to park their cash. Of course, this only makes the interest costs even more sensitive to fluctuations in interest rates, as more and more short-term debt needs to be constantly rolled over, but that is a discussion for another day.
A major source of funds for these T-bills, especially over the past six months or so, has been money coming out of the Fed’s Reverse Repo Facility. Without getting too technical here about what that is or why it exists in the first place, you can think of it as a place where both banks can park their excess reserves and prime money market funds can park their funds for one day and earn a stated rate of interest directly from the Fed. The amount of money in this facility had dropped from around $2.5 trillion at the end of last year to a little over $800 billion today. The rate of decline has actually accelerated, down from around $1.8 trillion just this August. If this rate of withdrawals from the facility continues, then it would be exhausted by the end of Q1 2024. This is in and of itself is not necessarily a bad thing – the facility had zero dollars it in March 2021 – but it does make me wonder where the marginal source of funding is going to be for US treasury debt come 2Q 2024.
For what it’s worth, here is my guess:
This mismatch in Treasury bond supply and demand will continue to put upward pressure on interest rates, especially around this time when the Reverse Repo Facility begins to run dry.
Higher for longer rates will continue to put pressure on treasury interest expense, putting further pressure on the Treasury to issue additional bonds to finance their own interest expense.
The rest of the world will become increasingly unwilling to buy US Treasury bonds given the Ponzi-like nature of the Treasury issuing record amounts of debt to finance, among other things, the interest burden on their own debt.
Despite Jerome Powell’s best intentions and stated goals of staying higher for longer on rates, in order to deal with inflation, and wanting to continue shrinking their balance sheet, they will be forced to stop both of those endeavors out of necessity (he may resign before caving into this).
With the Fed back at the table, cutting interest rates, and willing to print up loads more money in order to buy government debt, pressure on the banking system and commercial real estate market will be relieved, but then inflation will really take hold.
In fact, the unfortunate truth is that given the math around all of the above, we need inflation. There is no other realistic path forward. There is simply too much debt, everywhere, to make austerity, or dealing with the debt honestly, a viable option at this point. The Fed is ultimately going to be forced to choose between allowing the system to clean itself out though defaults and restructuring, or they will fire up their mouse-click money printers again, as they have repeatedly since the Great Financial Crisis of 2007-2008. My money is on the latter, perhaps after we have a new Fed Chairman.
So where does this leave us from an investment standpoint?
Short-term interest rates are as high as they have been in over 15 years. I’ve heard this opportunity referred to as “T-bill and chill.” At north of 5% on fully guaranteed instruments, with no credit or duration risk, it makes sense to me. This gives us optionality as opportunities present themselves, as I expect they will into next year.
To the extent that capital is being put at risk today, I think being mindful of the longer-term probabilities around inflation need to be considered:
While cash equivalents and bonds may offer an attractive short-term opportunity, they may make for a lousy choice in the face of structurally higher inflation going forward.
Things that should respond favorably to inflation, especially if they provide for life’s basic necessities, seem attractive. Stocks seem more attractive than bonds, but may well get hit hard if and when a recession hits.
Ultimately, I think we want to own things that can’t be printed and are by their nature limited in supply. There will be a lot of bonds coming down the pike for the foreseeable future. The gold market may well be anticipating this based on its recent behavior. Gold generally declines in price when interest rates rise, as it becomes comparatively less attractive to alternatives that pay interest, such as T-bills. Yet here we are with T-bills paying more than they have in 15 years and gold just traded at an all-time high in dollar terms. I think the gold market can see what’s coming next, clear as day.
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