• John Prior

The Roll

“Every week we roll over approximately $100bn in US bills. If US bondholders decided that they want to be repaid rather than continuing to roll over their investments, we could unexpectedly dissipate our entire cash balance. There is no plan other than raising the debt limit that permits us to meet all of our obligations”

“Let me remind everyone; principal on the debt is not something we pay out of our cash flow or revenues. Principal on the debt is something that is a function of the markets rolling over.”

Jack Lew, US Treasury Secretary, Senate Testimony on the Debt Ceiling, Oct 2013.

When the numbers get really big, the eyes glaze over. Billions, trillions; who cares? We saw this in the recent UK election which on many levels degenerated into a competition of who could promise to spend the most (non-existent) money. But politicians of all colours know that the electoral prospects of anyone who even raises the issue are dead-on-arrival.

Unfortunately, the numbers do matter. The $100bn a week roll in October 2013 that Lew referred to in the quote above is now the $225bn a week roll after growing at 15% compound per annum. The US Government must sell $45bn of bills and bonds every single trading day. That number will continue to climb next year, the year after and as far as the eye can see due to the trajectory of US deficits. This leads to one obvious question: Who is going to buy it all?

Historically, this was an easy question to answer. The US dollar’s status as the global reserve currency and the related large current account deficits meant that foreign demand could be counted on to hoover up US debt. That is no longer the case. Foreign central banks haven’t been net buyers of US debt for around 5 years. In the case of European and Japanese investors, this is largely because when adjusted for currency hedging costs, yields on US debt are now negative in local currency terms. In the case of China, given the tensions around trade and other geo-political issues, accumulating more claims on the US can hardly be attractive. Over-riding all of this is a US administration intent upon eliminating the trade surpluses that are the bedrock of the overseas demand for US debt.

This leaves the US private sector which to be fair, has been doing its best. Domestic private investors via their 401k retirement or money market accounts, have stepped in to fill the void. Additionally, the US banking sector, encouraged by new regulations has been a big buyer. Hedge funds too. But sooner or later the finite balance sheets of the US private sector become overwhelmed by the infinite financing needs of government.

Given the building requirement to roll more and more debt, one would have thought it would be in the US government’s interest to term-out the maturity of the debt as far as possible. For example, in 2017 Austria issued a 100-year bond at a yield of around 2%. With the subsequent fall in yields after the issue, those bonds currently yield 0.80%. This is an astonishingly good deal for governments and bad deal for investors. If the ECB hit their inflation target over the next 97 years, the bonds will lose 70% in real terms if purchased today.

However, this is where the billions and the trillions matter. The size of the Austrian 100-year issue was €5.9bn; a bit of fun for the hedge funds to punt around, but not overly relevant in the big picture. I’m not sure if US Treasury Secretary Steve Mnuchin has scoped out the bid for $5.9tn 100-year debt issue (roughly what they need to refinance in the next 6 months), but I suspect that the coupon required would send the US interest cost and hence budget deficit through the roof. The reality is that the US is financing more and more at the short end. Of the $11.5tn refinanced in the last 12 months, around 70% was done at less than 6 months maturity. The fact that the world’s pre-eminent economy and issuer of the global reserve currency is starting to look like a hedge fund in the way it finances itself is truly frightening and has major implications, not only from an investment perspective.

The simple fact is that the balance sheet capacity of the foreign and private domestic sectors will eventually be overwhelmed by the financing needs of government. Fissures are already developing. The repo spike in September is a prime example. Tinkering of regulations and capital requirements for banks can elongate the process however ultimately some unpalatable decisions must be taken. Either spending needs to be cut dramatically, taxes need to be raised materially, the debt will not be paid or someone else needs to buy the debt.

Cutting spending means slashing entitlements. This is the third rail of US politics. A generation of baby boomers think they have paid into the system all their lives and are now due. There is nothing that anyone can say that will change that view. The fact that there isn’t a pot of money that’s been squirreled away to fund it all is not relevant to them. Similarly, the current crop of taxpayers, the millennials in particular, are already struggling to make ends meet. They will not see why they should pay for the comfortable retirement of what they view as an already privileged generation. Taxing the wealthy polls well but the impact in total tax dollars isn’t significant. However, the overriding fact is that anything that reduces the budget deficit will be growth negative, ultimately sending the economy into recession and the deficit even further into the red.

The implications US defaulting on its debt obligations or even missing a coupon payment are so horrendous that for the purpose of this analysis, it can be dismissed. This leaves the final option; someone else needs to buy the debt. That someone else is the Central Bank. To extend our example from earlier, the US government could issue $5.9tn in 100-year 0% bonds that the Fed buys with new dollars that it can create at a keystroke. This would be a game changer. I extend this example not as a prediction but to illustrate the point and to demonstrate the direction of travel. In a fiat money regime, sovereigns that can print their own currency will never run out of money.

While some my find this line of argument intellectually offensive and certainly not found in the mainstream media, plenty of sensible people are saying exactly the same thing. For example, below is a quote from Ray Dalio is a recent Linkedin blog post.

“At the same time, large government deficits exist and will almost certainly increase substantially, which will require huge amounts of more debt to be sold by governments—amounts that cannot naturally be absorbed without driving up interest rates at a time when an interest rate rise would be devastating for markets and economies because the world is so leveraged long. Where will the money come from to buy these bonds and fund these deficits? It will almost certainly come from central banks, which will buy the debt that is produced with freshly printed money. This whole dynamic in which sound finance is being thrown out the window will continue and probably accelerate, especially in the reserve currency countries and their currencies—i.e., in the US, Europe, and Japan, and in the dollar, euro, and yen.”

We are in a tough spot. Any combination of positive real interest rates or balanced budgets will be toxic for economic growth at a time where the electorate is already disenfranchised. Either the Fed will grow its balance sheet to accommodate the levels spending required or it won’t. If it does, it will undoubtedly be helpful in the short run, although it will lead to a new set of problems. If it doesn’t, the next bubble will be in guns and canned food. I think it will.

History is clear; sovereign debt bubbles of the kind we are currently experiencing do not end in nominal defaults or price declines when measured in a currency that the sovereign can print. It is important that investors are aware of this.

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