WHEN WILL THE FED PIVOT?

4 October 2023

Of course , America will never default on interest payments, which currently make up about 40% of tax receipts, but with a 32 trillion dollar debt and a higher for longer or even higher, there will be effects on the value of the currency ... maybe not now, but in a year or two's time

So that is one thing that would worry other sovereign governments wondering where to put their surpluses - is the dollar safe ?

another point they will think about is the illegal sanctions levied on Russia and the confiscation of its treasure. Particularly given America's a hard line attitude that if you are not with us you are against us so for example where does this leave India and how certain can China be that it's one or two trillion dollars of American government bonds will not be confiscated?.

Growth is not going to be enough to keep up interest payments without printing let alone pay down the debt. But this just means currency debasement, as I say maybe not now but within a couple of years.

To fight inflation - which doesn't in all seriousness look like it is really going away the current CPI says 3.7% but if you use volcas method it is more like 11.5% - hire interest rates are needed also to support the value of the currency and ensure that the extra billion of borrowing can be absorbed.

And yeah higher interest rates will destroy the system - higher interest rates mean higher corporate refinancing costs and lower profits, plus now we are a year nearer to the refinancing cliff than we were when the fed started raising

And higher interest rates mean credit costs to customers increase and this will cut back spending, ie lower revenues in the first place. If spending falls then firms will start to lay off workers. In fact rising unemployment is the last domino in the signals that we are entering recession.

So what is the fed to do? Surely given a choice between protecting the system or protecting the currency, it will choose the system. This would mean we are talking about the famous and long anticipated pivot - QE and rates back to zero, expand the credit supply but at the cost of still further debt. Increased credit an inflexible supply of raw materials will just provoke inflation again. And expanding the money supply for a fixed supply of inputs and goods, may restore demand, but it is like adding water to your wine it waters down the value of the currency, it debateses the currency. 

No wonder governments with a surplus are selling U.S treasuries and buying gold they are moving away from financial assets and into hard assets These Are the safest in the coming crisis.

But now comes the 64-million dollar question. When will the fed start printing again? Will it be when the system shows signs of destroying itself - for example a market crash? Or will a more determined and subtle Fed let everything descend into semi-chaos before cutting rates and starting QE? Hasn't the last year or two been about the Fed bolstering its tools, in the form of higher interest rates and lower money supply, in preparation for the next (the last? Yikes!) crisis and recession?

More cynically still, more realistically perhaps, just consider the matter from the point of view of supply and demand. The supply is pretty much infinite as we have seen - the govt does not balance its budget, it just spends more and more and more, regardless of tax receipts. For this reason, the US Treasury requires 1.5 to 2 trillion dollars of extra debt every year for the foreseeable future.

The demand was from the fed itself as it was practising QE. Also the banks were major buyers - hundreds of billions - but last year both stepped away and now this left hedge funds as the major buyer. Hedge funds can use cash-settled futures contracts on US government bonds for various reasons, such as hedging their portfolio risk, speculating on interest rate movements, or gaining exposure to the bond market without owning the physical bonds extra 2%.

Next in line after the Fed, the banks and the hedge funds, come pension funds and insurance companies. These funds are conservative in outlook, and yet as was revealed last year in the UK's liability driven insurance crisis, in fact these pension funds invest in equities; while insurers go for fixed income - but corporate bonds rather than treasuries as the upside spread of maybe 2% is more than the downside risk. But after these potential buyers, who? No-one,so expect bonds to drift higher.

From the point of view of supply and demand then the supply is pretty much infinite while the demand appears to be evaporating in conclusion we can say that it will not be the fed lowering rates that determines the cost of money it will be instead the market and the direction seems to be up on yields which without fed intervention i.e restarting QE would destroy the bond market.

And yet QE results in inflation and eventually currency debasement.

Surely the Fed knows this! I strongly believe that the real and true strategy of the Fed, and it's only choice since raising rates beyond a certain point will destroy the bond Market and thus equities and financial assets and the economy itself. is to burn off the debt through inflation and currency debasement. 

If you believe this then you'll believe that despite Powell's rhetoric, the Fed will have to pivot, ie print to buy up the excess govt bond issuance. So you'll want to put your money into hard assets such as precious metals and commodities and not leave it in equities, you'll want to avoid endebted or low-yield equities.

Further, you'll want to believe that in some way after burning off the debt, there will be recovery and the US will keep its top dog place!