There are times when relying on a system to perform as intended is so critical, when the prospect of failure is so bizarre, that the effectiveness of the system must be taken for granted before we choose to engage it. The brakes of a car, the landing gear of an airplane; these things have to work exactly as intended simply because a malfunction would lead to immediate disaster.
Over the past 50 years, the US federal government has spent far more money than it has received. When the government spends more than its income, like any other business or family, it has to borrow the money from someone else. The government borrows money from institutional investors such as other governments, pension funds, insurance companies and mainly from banks. The system for borrowing this money is called the US Treasury market.
The US Treasury market is worth $27 trillion (source: Wall Street Journal), and it works in a very specific way. When the government needs to borrow money, the US Treasury issues bonds. These bonds are offered to a network of large banks called primary dealers. These primary dealers buy the bonds. Some bonds are held by banks for themselves, but most are resold to other institutional investors. Although these banks are obliged to buy the bonds offered by the government, they are willing to do so because they are convinced that they will be able to resell many of them to other investors.
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Bonds in the Treasury markets are constantly maturing and being repaid, often with new borrowing, in a continuous cycle of maturity and refinancing. Since the 2008 financial crisis, as bonds matured, new bonds were issued, mostly at interest rates well below those of maturing bonds, reducing the cost to the government of continue to borrow more money.
However, perhaps most importantly, since March 2009, the largest bank of them all, the Federal Reserve (the Fed), has been buying bonds that are resold to primary banks. Because of this near-constant presence of the Fed as a powerful buyer, over the past 14 years senior traders have come to take it for granted that the Fed would buy a good portion of the bonds issued by the government, which made them more willing to buy all the bonds offered by the government.
We should all know by now; the Fed was buying these US Treasuries from primary traders with new money it created for that purpose in a process called quantitative easing. This new money has increased the supply of money available in the markets, and more money in the markets generally makes the markets more fluid. Smoother functioning markets are thought to have proven more resilient during the two major crises of the past 14 years – the financial crisis and COVID – it is believed that they have helped our economy avoid a major crash.
After many years, the US Treasury market became accustomed to the Fed as a consistent buyer, to the point that the government, as a seller of bonds, felt encouraged to accelerate its borrowing, selling more bonds, and primary traders felt confident to buy all the bonds. the government was selling, knowing that it could resell it to the Fed. What could go wrong?
Well, unfortunately, all that new money ended up contributing to the inflation cycle that our economy is currently experiencing. Inflation is very dangerous for an economy, and in an attempt to remedy that, five months ago the Fed decided that it should no longer create new money contributing to the issue, and it stopped buy treasury bills from primary dealers, leaving a huge hole in the treasury market process. After months of not having the Fed as a consistent buyer of new Treasuries, primary market brokers seem to have worried about their ability to resell all the bonds the government sells. This reluctance is called liquidity stress, and it is very important to understand it.
For the financial system to work like the brakes on a car or the landing gear on an airplane, the US Treasury market must work smoothly. In 2023, a large amount of US government bonds are maturing and need to be refinanced, and unfortunately, in addition, the government seems completely unable to reduce the amount of new bonds it must issue to finance more and more expenses. Without the Fed to buy these bonds, questions arise as to how the US Treasury market will meet this challenge.
This week we experienced a controversial federal election. Issues such as abortion, trans protection, freedom of speech, election integrity and many more were vigorously debated. These problems will need to be solved over time, but over the next two years, the most important problem facing our country may come down to math. The government simply needs to refinance too many bonds and borrow too much money, and without the Fed as a buyer to facilitate this process, I’m starting to worry about the consequences. Also, unfortunately, this is an issue that I have not heard vigorously debated during the campaign cycle. Maybe he should have been.
The economic forecasts presented in this document may not develop as expected.
The opinions expressed in this document do not necessarily reflect the views of LPL Financial.
Marc Ruiz is a Wealth Advisor and Partner at Oak Partners and a Registered Representative at LPL Financial. Contact Marc at [email protected]
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