November 18, 2024 | Updated | In this issue of The Institutional Risk Analyst, we ask a basic question. Will the US bond market wait for President-elect Donald Trump to take office in January and unveil his agenda? Or will the long end of the yield curve surge even higher as the likelihood of a US debt default increases? BTW, President Joe Biden will let the Ukrainians take the gloves off before Christmas and strike targets deep inside Russia, a little parting gift for the incoming POTUS from the Party of War.
With the Russian military disintegrating and 100,000 North Korean soldiers "reportedly" headed for Kursk, according to sources favoring escalation, how long will the US and other NATO countries stay out of the Ukraine War? In fact, the Russians have training agreements with the North Koreans in the Far East. And they receive ammunition. Everything else is a lie designed by the Party of War to justify the ever increasing escalation.
Our first quarterly conference call was held last week for subscribers to the Premium Service of The IRA. We’ll be doing another call in Q1 2025. Watch for a placeholder for the next discussion via email.
In the space of 45 days, the credit markets have gone from certainty regarding falling interest rates to increasing fear of higher interest rates. “The economy is not sending any signals that we need to be in a hurry to lower rates,” Federal Reserve Chair Jerome Powell said during a speech in Dallas.
While Chairman Powell was inclined to be helpful to President Biden, he is inclined not to be helpful to Donald Trump and will now gladly drag his feet on further rate cuts. Given that Trump does not have much room to maneuver because of the rising budget deficit and LT interest rates, this sets the stage for a very public political confrontation with the Fed in the New Year.
Those of us who traded the Trump Casino bonds years ago through several bankruptcies get the joke. In the tertiary phase of debt default, non-payment becomes inevitable. If all of this were not enough, the Fed has no idea about the state of liquidity in the markets as we approach the end of the year.
Bill Nelson, Chief Economist at Bank Policy Institute, notes in his latest missive that "The Fed's guide for when to end QT may be unreliable." Specifically, the FOMC's calculus regarding the adequate level of reserves is subject to considerable uncertainty.
The interaction between the Fed's investment portfolio, the Treasury General Account and Reverse RPs, and bank investment decisions, Nelson relates, can change the correlation between bank reserves and interest rates from positive to negative to neutral "instantaneously." This means that Chairman Powell and the other members of the Fed's Board of Governors really have no idea whether there is sufficient liquidity in the system as the central bank slowly shrinks its balance sheet.
Truth to tell, nothing has changed since December 2018, when Powell et al almost crashed the US financial system except 1) the increasingly political stance of the Federal Reserve as a new Republican administration takes office and 2) the prospective level of uncertainty coming from the Trump White House. For mortgage lenders and the equity markets, increased interest rate volatility is going to be the challenge going forward.
For Fed Chairman Jerome Powell, the big question is when to push the red button and resign. Some progressives and market watchers were heartened when Chairman Powell pushed back on the idea that the President of the United States could fire him or other Fed governors. In purely technical, legal terms, this is correct. But as a practical political matter, no Fed chairman or governor can function without the support of the White House and the US Treasury.
Richard J. Whalen (1935-2023) agreed to be an advisor to former Merrill Lynch CEO and Treasury Secretary Donald Regan in Reagan I, but he laid out several conditions that we recount in the Second Edition of "Inflated: Money, Debt and the American Dream," to be released by John Wiley in 2025:
"Dick, I’ve been asked to become Secretary of the Treasury,” said Regan. Whalen replied: “I know, you’re on the list.” Regan said, “What should I do?” And Whalen said, “If you want it, take it, but for Christ’s sake stay away from Nancy Reagan and do not mess around with the Fed. Those are my terms if you want my help.”
Sadly such civilized rules no longer apply in the confines of Washington in 2024. There is no institutional respect for the Fed in the politicized world of Washington, in large part because the US is headed for a financial crisis. The politicians in both parties are growing desperate for a way out like rats fleeing a sinking ship. Suffice to say, it's 1861 all over again and Donald Trump stands in the shoes of Abraham Lincoln as the head of a broke government.
Fed Chairman are typically picked by the incumbent president and usually have served at the Treasury, on the Council of Economic Advisors or National Economic Council. Powell lacks this pedigree. President Jimmy Carter appointed Paul Volcker as chairman of the Board of Governors of the Federal Reserve System in 1979, just before losing the 1980 election to President Ronald Reagan.
Reagan was happy to have Volcker take the heat on inflation in the 1980s, but in the current scenario Donald Trump may not have much time to be nice. Such is the fiscal fiasco created by President Joe Biden, Treasury Secretary Janet Yellen and Congress that the US markets could see a significant market correction before Trump takes office.
The US government is running a cumulative deficit of $1.9 trillion so far in FY2024 ($302 billion more than the same period in the prior fiscal year when adjusted for timing shifts*), according to the Bipartisan Policy Center. Spending is rising faster than revenue, largely due to higher interest rates.
As our astute colleague Ralph Delguidice asked last week, does Trump even have an opportunity to roll out a new program before the proverbial debt comes due in the Treasury bond markets? Corporate debt spreads are relatively tight vs risk-free yields. Private companies are taking advantage of this fact in the new issue market.
But the reason corporate spreads are tightening is rising government debt yields and deteriorating sovereign credit default swaps spreads, not better corporate credit. That is bad. The floor of government credit default spreads is rising on a sea of unpayable public debt. There is a reason why the folks at FRED no longer publish US credit default swap rates.
The charts below come from David Kotok of Cumberland Advisors c/o Bloomberg & CMA, and show the widening of five year CDS spreads for the United States since 2019. David will be talking about the market for US CDS on the Money Show in Sarasota on December 7th. Suffice to say that the probability of default for the US has risen 4x since 2008.
Source: Bloomberg/CMA
Source: Bloomberg/CMA
What these two charts illustrate is that the cost of insuring against a debt default by the United States is rising significantly. While the ebb and flow of the markets continues, the LT trend is headed toward an eventual default. Indeed, the US seems to be on track to see debt spreads for the US rise above corporate spreads for the largest and most liquid private companies for the first time since WWI.
When President-elect Trump ponders his selection for Treasury Secretary, he ought to ask who will do a better job of managing a US debt default. Elon Musk has urged followers on X to support Howard Lutnick, former CEO of Cantor Fitzgerald. Lutnick is up against Scott Bessent, the founder of capital management firm Key Square, who reportedly wants the US dollar to remain the world’s reserve currency and use tariffs as a negotiating tactic.
“My view FWIW is that Bessent is a business-as-usual choice, whereas @howardlutnick will actually enact change,” Musk posted on Saturday. “Business-as-usual is driving America bankrupt, so we need change one way or another.” But do either President Trump or Elon Musk understand how little time remains for political posturing?
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