Bond yields for U.S Treasuries have been rising at one of the fastest paced rates in U.S. history. This has caused concern on Wall Street and has become a major focus. Bond King, Jeffrey Gundlach, has said that the yield will rise and as the 10-year Treasury yield approaches 3%, it will cause market turmoil. He has encouraged investors early last year to also invest in Gold. Recently with the U.S. stock market correction, many investors have lost tens of thousands of dollars. A total of over $3 Trillion was lost in market volatility. Many analysts are telling investors not to sell because the economy is on firm footing and this is a normal correction. The U.S. stock market only had a taste of the potential downturn caused from higher bond yields which was due to the Fed unwinding their balance sheet at the start of this year. The biggest test yet to come according to Morgan Stanley, uses the analogy of a meal in that this is an, “Appetizer, not the main course,” which is how the bank strategists recently described the sell-off. Goldman Sachs economist Daan Struyven reported that if there was a surge of the 10-year Treasury yield to 4.5% by year-end, it would cause another 20% to 25% decline in equity prices. Brian Levine, co-head of global equity trading at Goldman Sachs, recently sent out an email to the investment banks larger clients which stated a stunning prediction, “The Buy the Dip Regime is now over. The ‘buy the dip’ mentality needs to be thoroughly punished before we find the bottom.”
Government Debt and the Bubble
I am adamant when I say this correction was long overdue, since a 10% correction should happen every 3 years. Historically, every 7 years a 20% correction has taken place and we are still long overdue for that. What keeps that from happening currently is the economy is booming, yet at the cost of government debt ballooning partially due to the tax bill recently passed. I said last year that I fully support most of President Trump’s agenda. I also said that unfortunately this will cause our country’s debt to soar and it is. At some point though this will run out of steam since you can’t fund an economy via ballooning personal, corporate, and government debt. When the music ends, it will end abruptly and sharply.
The Fed Balance Sheet in a Bubble
In 2007 the Fed came to the rescue and took major action to stop a meltdown. This action by the Fed significantly oversteps their role. Instead of having normalized free markets, they artificially induced money, supplementing the stock market and economy. This “Money Drug” was a major contributor to the Dow rising from 6,600 points in 2008 to its recent levels, because of the program Quantitative Easing I, II, and III. During this time the Fed’s balance sheet ballooned from $550 Billion dollars to $4.5 Trillion Dollars. This is something no Central Bank has ever done in history. In addition, the Fed lowered rates to an unprecedented artificially low rate of .25%. The Fed era of an eight-year-long period of monetary accommodation has ended, creating a bubble that not even the Fed knows how to deal with. They admit this openly. The Fed is now the largest owner of U.S. Treasuries. It holds approximately $2.5 trillion in Treasuries; the other large portion of their balance sheet is Mortgage Back Securities. When it comes to looking at their balance sheet the markets have more questions than answers. As they look to the Fed they are scratching their head in dismay. The biggest question is, what will happen to the value of the dollar when the Fed stops buying Treasuries? The other question is what will happen to the economy when the Fed is also moving rates back up to a normalized level?
The Fed Selling Treasuries
In last month’s newsletter I wrote about how China announced it was halting buying U.S. Treasuries and even talking about selling them. This caused a couple of days of market volatility. Now it is the Fed’s turn to sell U.S. Treasuries. This just compounded our country’s financial problem. Who is going to buy Treasuries to continue to support our debt? If that buyer is the Treasury, how many more Treasuries will the Treasury have to create to receive those funds for payment to the Fed when they sell? Sound like a shell game, a Ponzi scheme? Unfortunately, by definition and structure it is. The Fed has said for over 5 years they will unwind their balance sheet eventually. They do not know what negative effects it will have on stocks and other markets. The two individuals, Joseph Gagnon and Brian Sak, who the Fed used to create Quantitative Easing I, II, and III, were called on again to figure out a way the Fed could unwind (sell) their $4.5 Trillion Balance Sheet and move the interest rate to normalized rates. Every test model failed; all created market turmoil. The Fed’s plan to unwind is to sell $20 Billion a month for the first quarter, $30 Billion a month in Q2, $40 Billion a month in Q3, and $50 Billion a month in Q4. By 2019 $50 Billion a month and every year after until the Fed deems the level of its holdings are “normal”. Under QE unwind, the Fed allows part of those maturing securities to “roll off”, rather than repurchase. Let’s look at what happened. Treasuries mature mid-month and at the end of the month. With the exception of a small number of Treasuries maturing in September through December of 2017, the month of January in 2018 was the first major sell off of Treasuries by the Fed. On January 31st, $27 Billion in Treasuries matured. The Fed “rolled over $16 Billion, (replaced them) and allowed $11 Billion to, “roll off”, (got paid for them). This caused the Dow to drop 7.6% in three days.
The Dow continues to fall and as of this writing is down over 10% this year. While doing this, their set target for normalized rates are between 3.5%-4.5% both to be done over the next 2-3 years. Keep in mind that only a first time selling of $27 Billion in U.S Treasuries by the Fed has caused all of this. The Fed is going to do this every month.
Legendary macro trader, Paul Tudor Jones, predicted that tax reform would have huge implications on the market and they did. Jones, who rarely make public comments on the markets, said in early February, that he would rather be holding hot coals than U.S. Treasury bonds. What does this tell the world when our own central bank, the Federal Reserve is selling our dollar? Why are they selling Treasuries? The obvious explanation is that the Fed could be losing money. Depending on the term of the Treasury and when it was issued, the Fed is losing money by holding those Treasuries when yields rise like they have been. Rising yields creates lower value in Treasuries. The other reason why the Fed is selling might not be so obvious. Previous to the Fed expanding their balance sheet, the Fed was leveraged at 7 to 1, which by Central Bank standards are a normal to slightly elevated level. In 2007, the Fed had to inject large quantities of capital into the financial system since movement of money came to a halt. We were days away from a “Great Depression” type of an era. Quantitative Easing or QE was created not just once, neither twice, but three times. By expanding the Fed’s balance sheet it created significant risk. The Fed’s balance sheet is now ballooned and is leveraged at 77 to 1. Never in the history of the world has a Central Bank leveraged their balance sheet this way, let alone a Central Bank that is the world reserve currency.
We all know there will be another downturn. It is not a matter of if, but when. Most people know that corporate and government debt wasn’t “fixed” in 2008. Commercial Banks are 2.5 times more leveraged today than in 2007. The next crisis, when it hits, will be more severe and the Fed cannot be overly leveraged. My thought is the Fed knows we are at the end of the business cycle and they need to get lean on their balance sheet to be able to leverage again when needed. By the Federal Reserve actions of selling Treasuries, they are indirectly confirming that there will be a more severe downturn than 2007. Looking at other Central Bank it only adds to the problem. There is a total of $13.6 Trillion of securities on the balance sheet of Central Banks. What will happen if The European Monetary Union starts to sell their balance sheet? How about if Japan joined in and also sold? There is an old saying “Bull Markets don’t die of old age; they die by Central Banks.”
The Treasury Issuing Treasuries to Support Massive Government Spending
The Treasury issues a Treasury Bill to raise money for a couple of reasons:
- To fund our governments overspending, which is called a budget deficit.
- The Treasury also creates a Treasury, to create revenue for itself and to have the funds to buy back Treasuries that are maturing. You noticed I used the word “create”. That is what actually happens. When the Treasury uses the word “borrow” it is synonymous with the word “create”.
The Treasury has previously warned it would increase Treasury Auction Size, in other words, create more new Treasuries. Goldman Sachs was being more realistic and calculated in mid-January, that the Treasury will set to more than double the number of Treasuries this year. Scary fact! On February 5th, the Treasury announced it expects to borrow (create) $955 Billion in 2018, an 84% jump over 2017, which was $666 Billion. Putting it into perspective it was $560 Billion in 2016. Government spending is going up. The U.S. government is spending more than any other time in history and has not enough monies coming in to support Congressional spending. Government spending is now $1 Million a minute! Our government is addicted to debt. This week the U.S. Treasury will create $258 Billion of Treasury Debt to keep funding the government. Let’s put this into perspective. It took 188 years of government operations to have a government debt of $258 Billion and our Treasury is now doing that in a week to fund government debt. Over the next 5 months, and with no more spending bills being passed, the National Debt will surge to $21.1 Trillion. Let’s add another scary fact: next year our government will have a $1.1 Trillion budget deficit, the largest ever in U.S history relative to GDP. Add that also to the National Debt. Again, more Treasuries will have to be created in the future, but let us come back to the present moment that we are in. On February 15th the Treasury released their annual report describing a gigantic shortfall that was actually $1.16 Trillion. Even more Treasuries are needed to be created, not just because of government, but the Federal Reserve and other central banks are selling massive amounts of Treasuries. As a result of this borrowing and the Fed selling, the 10-year yield in Treasuries rose to 2.9%. This is creating a bubble in the Treasury market of a huge surplus, a gluttony of Treasuries. On February 20th, Bloomberg News reported this, “The market is being hit with a deluge of Treasury Bills helping to push up the rates that borrowers demand.” Thus, the reason why yields in Treasuries have moved higher and will continue to do so to attract buyers to hold our debt. How about this headline from February 20th…“Historic Market Test On Deck: Record $179 BN in Treasury’s For Sale Today, Quarter Trillion This Week.”
We have history being made…out of thin air and call it a Treasury Bill.
There are many bubbles out there, yet the two biggest which should be our greatest concern are: A Treasury bubble and a government debt bubble. Both are being ignored, both are unsustainable. Keep in mind we are just starting this process. This will not end well at all. This is one reason why Jeffrey Gundlach and many others are recommending Gold in your portfolio now as a must. They see the writing on the wall and now hopefully you do as well. Call your Account Representative today to secure your financial future and learn what types of Gold are best for you.