A Painful, but Inevitable, Return to Normalcy

Why normalizing Treasury's maturity schedule will disturb financial markets

We’re just a few links into the chain of destruction, and things are already starting to get fun. Or maybe another f-word? As federal finances implode under their own weight, we have a front row seat to the show, offering good perspective on where we’re going.

First, here’s the current situation: the US is running $2+ trillion annual deficits. The federal debt is about to exceed $35 trillion. In fact, it may have done so last Friday, we just don’t have the numbers in yet. On Thursday of last week, the debt had breached $34.998 trillion - for the Treasury, that’s within a rounding error of the next milestone.

Putting aside the elephantine task of ever repaying that debt—something we perpetually put off until the future—it still needs to be serviced today. And that bill has exploded.

The interest on the debt set a new record in June, exceeding $140 billion for a single month. That’s an annualized $1.7 trillion—just for interest.

To clarify, because the maturity schedule of Treasuries is very uneven, we don’t see consistent interest payments from month to month. T-bonds and T-notes only pay interest biannually and T-bills only pay out when they mature, which is anywhere from 4 to 52 weeks.

In other words, interest paid on the debt for July could easily exceed $140 billion, but it could just as easily drop way below that amount. What’s important here is the trend, and we can see that when we look at the annual or even quarterly data.

Here again, the numbers are going parabolic. In the second quarter of this year, interest on the debt was running at about a $1.1 trillion annualized rate.

And it’s getting worse.

To understand why is to understand how we got here. In short, the government spent too much money it didn’t have. Furthermore, the bureaucrats needed to hide just how much they were spending, otherwise people might have been up in arms.

It’s not so much the spending that people would object to. After all, every voter wants the government to spend more money on him. Instead, people don’t want the pain of paying for all the goodies that politicians are always promising.

This is why interest rates were made so artificially low for so long - it allowed the government to borrow at rock-bottom rates and hide the true cost of all its spending. Even as the debt exploded, the cost of servicing that debt actually fell.

It’s important to understand that the real killer is not the size of the debt per se, but the cost to finance it. It’s just like how a person doesn’t care so much about the price of a home as he does the monthly payment, because the latter is what needs to fit into his budget.

Obviously, the home price is a huge factor in that monthly payment, but it’s not the deciding factor. For the Treasury, any size debt is manageable, so long as the cost to service that debt fits into the annual budget of incoming tax revenue.

While a homeowner has the option of locking in a rate for 30 years on an asset that usually appreciates in price, the Treasury doesn’t have those advantages. It never pays off debt in any meaningful sense while it’s constantly borrowing more and at such varied maturities that it’s as if the whole federal debt were on a pseudo-adjustable-rate mortgage.

As rates ramped up to cool the inflation caused by both the artificially low rates and excessive government spending, the interest expense on the debt began rising, and fast. Once again, the bureaucrats tried to hide the cost.

Yellen began radically changing the maturity schedule of the federal debt, running the Treasury almost like a hedge fund, in anticipation of Powell & Co. cutting rates several times this year.

Instead of the usual mix of short-, mid- and long-term Treasuries, Yellen reduced offerings of new bonds and notes and didn’t replace some of the old ones at maturity. Instead, she flooded the market with T-bills.

Like all debt markets, Treasuries have the rules for Supply and Demand reversed. In other words, increasing supply of issuance doesn’t decrease price (interest rate) but increases it. That’s because increasing the supply of debt is really increasing the demand for loanable funds. The nomenclature is backwards in modern parlance because, in our fiat monetary system, debt is money and serves as tradable securities.

So, the huge increase in T-bill issuance drove interest rates higher on those securities, without having as much of an impact on T-notes and T-bonds. This completely destroyed what was left of the yield curve, already damaged by Powell & Co.’s own manipulations.

Normally, a borrower pays a premium for keeping the lender’s money for a longer period of time. All else being equal, term increases yield on debt and associated securities. Not so today, because Yellen is actively engaging in yield curve control, similar to what she did during her time as Federal Reserve Chair.

The rationale here is two-fold: shorter-term debt allows the treasury to take advantage of rate cuts (soon?) and—more importantly—many private market rates are based off of rates on Treasuries, especially the 10-year and 30-year.

Pushing trillions of dollars out of longer-term debt and into T-bills has created a very inverted yield curve (shorter term = higher yields) for Treasuries but also created considerable inefficiencies. Yellen’s yield curve manipulations account for about 10% of the interest being paid on the debt - that’s over $100 billion annually.

Despite the higher cost to taxpayers, officials will point to the artificially low rates on the 10- and 30-year as proof that everything is fine. The scary part is that the maturity schedule of Treasuries has to normalize eventually, and that’s where things get really ugly.

So, that’s where we are and how we got here. Now, where are we going?