Understand one of the most unique financial moments of our time
Updated: Jun 8
Unbeknownst to many Americans we are embarking on one of the most interesting financial moments of our time. I even believe our grand kids may ask about it one day. To me it feels like watching a Rocky movie. There are two fighters and one of them is the underdog you are suppose to root for. The other is the antagonist that looks like the sure victor. Of course you always hope Rocky wins. But as always in a Rocky movie- he is stuck in a corner and nobody can see a way out.
Right now the Federal Reserve Bank of the United States is our "Rocky". The clear and obvious opponent to the our "financial Rocky" is rising bond yield's. These two fighters have gone the 12 rounds since the financial crisis in 2008 and we are now setting the stage for the final round.
The ten year treasury bond is a very important bond in the U.S. economy. This bond is tied to a lot of debt that you may not know about. Student debt payments rise and fall depending upon how the ten year is behaving. Mortgage rates also fluctuate depending upon the ten year yield.
UNDERSTAND THE FIGHT: During the last decade and especially the last year- The US economy has packed on a lot of debt. The service on this debt is becoming more expensive. Thus we will strangle our growth as we try and rebound from covid-19. However, this is only the beginning. Our government spending is about to finally become a problem. The problem nobody thought would ever become a "problem" is here.
In 2020 the US government spent $6.5Trillion. Our tax revenue totaled about $3Trillion. We have a spending surplus of $3.5T. How do we fund this $3.5T in over spending? Well, we sell treasuries much like the ten year treasury shown above. These treasury auctions then fund our lavish over spending because other government's around the world were willing to seek shelter in the US dollar.
Now, please understand how bond yield's work. The yield is the interest the US government pays for borrowing principal. The yield is simply the price to borrow money. When more governments want to loan us money the US government gets to auction these bonds at a lower yield (price) due to the demand. When there is lackluster demand for our treasuries then the US government raises these yields to attract suiters.
Why is the music about to stop? Well our government has been able to borrow at these low rates because our inflation has remained low. That low inflation is changing and the world can see it. Due to our rising inflation governments around the world now have to hedge currency risk when loaning the US money via purchases of US treasury bonds. It simply doesn't make sense for Japan to make 1.7% on a ten year treasury when our inflation erodes away those gains when swapping back to the Yen.
So why is Rocky stuck in a corner? Due to the fact governments haven't been as willing to loan us money-- our Federal Reserve has been expanding the money supply in order to create these loans. These new loans then create more inflation. As the inflation increases governments have a lesser desire to loan us money. Therefor the treasury yields keep drifting higher to attract demand. Obviously if these treasury yield's continue to rise then our debt will become more expensive.
So what is going to happen? In the meantime the Federal Reserve is trying not to be the one to blink first. By "blink" I mean pressing the gas on our money expansion program via bond purchases from the Federal Reserve to the treasury.
Why would the Federal Reserve need to step on the gas? The Federal Reserve is currently expanding the money supply at $30B per week. Our 2021 deficit spending is going to surpass $3.5T and we don't have the money to pay for it. At this rate the Federal Reserve is expanding the money supply at $1.5T per year to "pay" for our deficits. That means the US government still has to borrow at least $2T from governments around the world. The only question is... will these governments want to loan cash at 1.7% interest to a currency that is continuously being devalued?
If foreign governments decide to loan the US the money than Rocky would escape from the corner to make another movie. However, if other countries decide it is time for the US to pay for its own bills-- than we will see a very different Rocky movie than we are used to. If that is the case we will see the US Federal Reserve ramp up its weekly bond buying purchases from $30B per week to who knows how high. This action will be the only way to drive interest rates down to pay for our past spending spree and the one in the future.
Of course this will ultimately hurt the dollar and make our imports a lot more expensive. By and large we end up paying for this behavior via inflation.
What is an investor to do? Understand this premise. Reach out to me if you have any questions--And of course keep a look out to see what the Federal Reserve decides to do over the next couple of months. It could be an interesting ending.
John Lawrence is an investment advisor and founder of J.A. Lawrence Wealth Management.
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