Email of the day on debt
Comment of the Day

February 18 2021

Commentary by Eoin Treacy

Email of the day on debt

In the 1960s David Cameron's father, Ian who was the head of the Gilts department, taught me when I was working. at Panmure Gordon, that states never repay their debts. They issue new bonds to refinance old ones when they come to maturity. Apart from President Andrew Jackson in 1835, there is no modern example of a state repaying the National Debt. It is about time that experts and journalists stop causing anxiety among older people who think that states are burdening their children and grandchildren with future debt repayments.

Eoin Treacy's view

Thank you for this personal account. I agree governments never pay back their debts. They always issue more debt. However, the money for the bonds has to come from somewhere. If the yield is high enough it will siphon private savings from the economy to fund the government. If the yield is not attractive, the central bank will have to print the money and buy the bonds.

In the first case, the currency strengthen, growth has a harder time raising capital but value should do well. In the latter, they devalue the currency to fund government. All private savings are eroded. Those with savings pour them into financial assets to hedge against the falling purchasing power of the currency.

No one is for one moment thinking the debt will ever be paid back. The sheer size of the debt today means the cost of servicing the debt is going to become a problem. We are rapidly approaching a point where significant remedial action will need to be taken. Since fiscal austerity is off the table, we are about to see a reamplification of money printing.

That’s why commodities are so firm. All of that new money will be ploughed into financial assets and infrastructure projects. I’ve been at pains to highlight how interest rate sensitive the growth/innovation sector is. The higher yields go, the greater the potential we are going to see a correction.

The challenge is that the Federal Reserve is probably waiting for a stock market pullback to the trend mean before acting. They want the market to tell them how high a yield will be absorbed because the Fed has stopped predicting. They are now an evidence-base institution.  

The other way to think about it is they will persist on the current suite of policies until something breaks. The last time they did that was in 2018 and the repo market broke.

This article from ZeroHedge includes extensive quotes from Zoltan Pozsar’s recent Money Notes. Here is a section:

As the Credit Suisse plumbing experts writes next, "this roughly $1 trillion decline will occur either through waves of fiscal spending, which will expand deposits and reserves at large banks...or, if spending is too slow to meet the $500 billion target, through bill paydowns. Coupon issuance will be $1.4 trillion over the first half, and depending on whether the spending or paydowns scenario dominates, coupons will be bought mostly by banks, or shadow banks."

Which brings us to the key part: why we are about to see another burst of fireworks in the repo market where rates are about to go negative:

Banks don’t have the balance sheet at the bank operating subsidiary level to add $1 trillion of deposits, reserves, and Treasuries: J.P. Morgan can’t grow more due to G-SIB constraints; Citibank flat-lined its balance sheet growth already; Bank of America has the capacity to add only $150 billion of deposits and HQLA; and Wells Fargo’s $500 billion capacity is constrained by its asset growth ban.

Unless we get SLR relief at the bank opco. level, or Wells Fargo’s ban is lifted, banks will have to turn away wealthy households’ and institutions’ deposits, which will then go to money funds. But money funds will face a constraint too: the marginal asset they will direct inflows into – the o/n RRP facility – is capped; each money fund can place only $30 billion into the facility, which is too little.

Banks’ balance sheet constraint becomes a collateral constraint for money funds, and collateral constraints may surface in both the spending and paydown scenarios. Collateral supply from coupon issuance will absorb this cash over time, but money markets react to what happens now, and with $1 trillion of new cash, there may be many pockets of collateral scarcity as these flows play out in real time.

The knock-on effect of the Treasury drawing down its massive stockpile at the Fed is going to create shockwaves in the repo markets. We are now revisiting the fact that the repo market represents an unlimited call on the Fed’s balance sheet.

They have no choice but to support it with whatever capital or buying power is required. The alternative is a complete freeze up in the global financial system similar to 2008. They won’t let that happen again so significant additional intervention is likely at the first sign of trouble.

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