Yesterday, the Bureau of Economic Statistics (BEA) announced U.S. Gross Domestic Product (GDP) grew at a feverish 4.9% during the 3rd Quarter of 2023. If you had told me earlier in the year the economy would post such a quarterly number, I wouldn’t have believed it. In fact, I would have bet you a beer otherwise.
Frankly, there has been very little in the tea leaves to suggest such imminent rapid growth. Far from it. After all,
- The money supply, as defined by M2, has fallen almost $1 trillion from its July 2022 high.
- Loans and leases on bank balance sheets were essentially flat from March through the end of July.
- Leading Economic Indicators have been negative for 18 consecutive months. Regional purchasing manager indices (PMI) have been dreadful.
- The yield curve (2-Year minus 10-Year U.S. Treasuries) has been inverted for over a year, and the hits just keep on coming.
In fact, I could have probably made a better case for a recession than a sudden, sharp acceleration in growth. However, the data is what data is, even if it is kind of hard to grasp.
Interest Rates and Treasury Yields
It is precisely this growth which is to blame for the recent surge in bond yields, or so says Treasury Secretary Janet Yellen. In the article in the preceding hyperlink, Bloomberg writers Viktoria Dendrinou and Peggy Collins wrote the following:
Treasury Secretary Janet Yellen said that the surge in longer-term bond yields in recent months is a reflection of a strong U.S. economy, not the jump in government borrowing driven by a widening fiscal deficit.
“I don’t think much of that is connected to the US budget deficit,” Yellen said at an event in Bloomberg’s Washington office Thursday. “We’re seeing yields go up in most advanced countries.”
The increase in yields — which has taken benchmark Treasury rates to the highest levels since before the global financial crisis — is instead “largely a reflection of the resilience people are seeing in the economy,” she said.
As former tennis bad boy John McEnroe might say: “you cannot be serious!”
To be sure, some of the sharp rise in interest rates over the last couple of years might be due to economic activity. However, to say bond yields and exploding fiscal deficits are connected is an amazing statement from a senior official. The word disingenuous actually comes to mind.
Here is the skinny.
The Federal Reserve has essentially backstopped the U.S. Treasury market for over the last decade. It did so by bloating its balance sheet, by buying government debt of all types, from $891.2 billion in December 2007 to a high of $8.97 trillion in April 2022.
For grins, the yield to maturity of the 10-Year U.S. Treasury was 4.03% at the end of 2007 and 2.94% in April of last year. Hmmm. Weird that.
Unfortunately for bond investors, since last April’s balance sheet high, the Fed has been shrinking its balance sheet by either selling or not repurchasing bonds upon maturity. As of 10/18/2023, assets at the Fed have fallen to $7.93 trillion, fully $1 trillion less than 18 months ago.
Not-so-coincidentally, the yield on the 10-Year touched 5.00% for a fleeting second earlier this week.
You have to remember; interest rates go up when bond prices go down. Prices for anything will go down when supply is greater than demand. The inverse is also true. Care to guess what has happened to the supply of U.S. Treasury debt over the last 18 months as the Fed has been slashing away at its balance sheet?
Debt
According to my handy-dandy Bloomberg, the U.S. Treasury Total Public Debt Outstanding was $30.37 trillion in April 2022. Last month, September 2023, it had mushroomed to, get this, $33.17 trillion. This is an increase of $2.8 trillion, even as the BEA reports U.S. GDP grew at a 4.9% annual rate last quarter.
Oh, and did I mention the official ‘U.S. Treasury Major Foreign Holders Total’? This is the amount of Treasury debt foreign investors are known to hold, which peaked in December 2021 at $7.74 trillion. In August 2023, it was $7.71 trillion. While not a massive drop, consider this, in December 2007, foreigners held $2.35 trillion worth of Treasuries.
So:
- reduce demand from the largest buyer of U.S. government debt by $1 trillion,
- have demand from the second largest buyer (foreigners) stagnate AND
- increase the supply by almost $3 trillion?
This means, for all intents and purposes, the domestic private sector has had to finance an additional $4 trillion coming out of Washington.
Hmm.
No matter how hard you try, you just can’t escape Econ 101. Further, comments from public officials don’t often gibe with economic reality. Consider the following paragraph from Bloomberg’s Dendrinou and Collins:
Many bond market participants have pointed to the sharp increase in the federal deficit as being a key factor behind the increase in yields. The increasing supply of Treasuries comes at a time when traditional big buyers, including the Fed and other major central banks, have pulled back on bond buying. This has led the Treasury to rely more on hedge funds, mutual funds and pension funds to buy the new debt, which are more price-sensitive and in turn may require higher returns.
What the authors arguably missed is the likelihood that domestic commercial banks probably aren’t reaching for yield “out on the curve” like they were leading up to 2022. Why take the additional interest rate risk when a 2-Year Treasury actually pays more? Especially after higher rates have been blistering bank bond portfolios, pulverizing capital in the process?
Inflation
To be sure, you can’t overlook inflation when discussing the spike in interest rates.
However, consider this. The yield to maturity on the 10-Year Treasury Inflation Protected Security (TIPS) has zoomed out to 2.42%. This represents a real, inflation-adjusted return investors are currently demanding to buy the security. This is the highest level since the end of 2008. Further, for grins, the yield on this security was 0.0% in April 2022, which was, again, the high-water mark for the Fed’s balance sheet. Interestingly, inflation expectations have fallen roughly 60 basis points since that time.
If that is a little too arcane, let me explain it another way.
- In April 2022, before the Fed start shrinking its balance sheet, the trailing 12-Month Consumer Price Index (CPI) was 3%. The yield on the 10-Year Treasury was 2.94% and the 10-Year TIP was 0.0%.
- Currently, the CPI is 7%, the 10-Year Treasury closed yesterday at 4.85% and the TIP came home at 2.42%.
Hmm. Inflation is much, much lower than it was before they started trimming its balance sheet and interest rates are much, much higher. Again, hmm.
Basically, there is only one way to put it: investors are simply demanding a higher real rate of return on their Treasury holdings than they were not so long ago.
I would contend much of the reason for this is because the domestic private sector is bearing the weight of financing Washington’s budget deficit, as opposed to the Federal Reserve and foreign investors.
Intuitively, individual and institutional investors are going to care more about their investment return than bureaucratic central bankers.
This seems pretty straight forward to me, albeit a little nerdy. Okay, a lot nerdy. However, it appears to baffle Treasury Secretary Janet Yellen, at least officially.
That leaves me with only one thing to say, both to those who declare our massive budgets deficits aren’t having an impact on interest rates AND to the amazingly strong 3rd quarter GDP report. Care to guess what that is, as if you didn’t already know.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.