One of the main objectives of this commentary over the last seven years has been to chronicle the tremendous explosion in federal debt since 2008. This increase which has forced us into a new monetary regime—a world in which central banks in developed countries have been forced to both lower short-term rates to near zero as well as purchase unprecedented amounts of longer-term notes and bonds, all in an effort to prevent the interest payments on the national debt from blowing up the budget. For instance, if interest rates were to instantly revert to the conditions extant just ten years ago, the interest due on the debt during the current fiscal year would be more than $1 trillion. To put that number in context, it is roughly 30% of federal revenues in 2017, or more than is paid out in Social Security benefits (currently the largest component of outlays.) We cite this number not to be alarmist, but rather to emphasize that it is extremely unlikely that we will ever return to the interest rate norms that existed prior to 2008.
Despite this mathematical constraint, the Federal Reserve has embarked, albeit at a glacial pace, on a path which would both lead us back towards “normal” financial conditions. The US central bank has promised to both raise short-term interest rates and reduce its holdings of Treasury debt and mortgage-backed securities, a step which some have referred to as quantitative tightening (QT). To date, however, the talk of the Fed cutting its long-term Treasury holdings have been just that—talk. In fact, the Fed has purchased over $14 billion in 30-year issues in the last year.
All that is supposed to change in 2018. The Fed has promised to begin reducing its balance sheet by $30 billion per month, and that it will do this not only by not reinvesting the proceeds from maturing securities but also by selling some of its holdings. The pertinent question is whether or not this selling, when combined with a continued large issuance necessitated by the budget deficit, will begin to erode the will of bond buyers and result in increased interest rates at the long end of the curve. After all, the Treasury continues to sell roughly $14 billion in 30-year bonds every month, and last month the amount of Treasury debt held by the public with maturities greater than 20-years exceeded $1 trillion for the first time ever.
A five-fold increase in supply in the last decade and a doubling in the last three years, combined with a Fed which is switching from net buying to selling could lead to unanticipated consequences.
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