Author: Dr_Gingerballs, Crypto Kol
Source: Dr_Gingerballs X account
Compiled by: zhouzhou, BlockBeats
Editor's note: This article analyzes the abnormal impact of the Fed's interest rate cuts on bond yields. The core point is: In the current environment, the Fed's interest rate cuts will lead to lower short-term interest rates, but due to the large scale of debt and deficits, the market requires higher yields on long-term government bonds to maintain the balance of the investment portfolio. In addition, the operations of the Federal Reserve and the Treasury Department will invisibly transfer public wealth to asset holders, and the economic recession will make this problem more serious.
The following is the original content (for easier reading and understanding, the original content has been reorganized):
Tomorrow is a key day for the Fed, with many expecting a 25bp rate cut. I am not surprised that bond yields rose sharply after the last 50bp rate cut. So why would a Fed rate cut in 2024 lead to higher bond yields?
For the sake of brevity, I have designed a chart to best illustrate my point. The chart shows the annual growth rate of the US deficit and the total interest paid on existing Treasury bonds (data directly from the Treasury website). Note that before 2008, the US debt-to-GDP ratio was maintained at 40-60%, which means that the private sector (banks) can issue a lot of money relative to the public sector, and the funds can be used to purchase new debt without worrying about the high proportion of Chinese bonds in the portfolio. In fact, it is beneficial to issue Treasury bonds for the market to hold high-quality assets.
But in 2008, the Fed’s “original sin” occurred, and Pandora’s box was opened. Faced with a dramatic drop in tax revenues, the government spent a lot of money, and the Fed monetized it through quantitative easing (QE). People worried that this would cause inflation, but surprisingly, inflation did not appear. This laid the foundation for massive government spending without consequences. So, the Fed can buy our debt, keep interest rates low, and there is no inflation penalty? "Free money"!
The government spent relentlessly. From 2009 to 2013, debt rose from 60% of nominal GDP to 100% and remained there until 2020. Many people forget that we already had some inflation problems before the pandemic, and the Fed was raising rates. By exporting inflation overseas, the benefits we had gained gradually disappeared. In retrospect, we were already heading towards a dangerous situation.
In 2020, a new money printing program began, further confirming the end of our free money era. When the Fed monetized these expenditures, inflation quickly soared. There is no more QE without causing inflation.
So what did the Fed do? They stopped printing money, and the Treasury continued to issue debt. That is, the Fed no longer bought those Treasury bonds, which meant that the private sector had to absorb them.
Skipping some of the details, in essence, the Fed and the Treasury created an environment where they rewarded debt holders by raising short-term interest rates and concentrating all debt on the short end. This was great for Treasury holders because they could buy this additional debt, get the cash flow, and take on lower term risk. This equaled "more free money."
It is worth mentioning that this free money is a wealth transfer from the public to asset holders (the rich). The Fed raising interest rates and the Treasury reducing term risk are intentionally directing funds from the poor to the rich. The deficit is borne by everyone, while the interest on the national debt benefits only a few.
But there's a problem. The Treasury has to issue a lot of debt, which means the private sector has to buy it (because the Fed won't risk inflation by buying it). But the private sector wants to maintain a certain percentage of bonds in its portfolio. The only way to avoid Treasury bonds gradually taking over the entire portfolio is the interest payments.
This brings me to the point of my chart. In an environment where portfolio allocation determines valuation, and portfolio allocation is relatively rigid, bondholders will, in aggregate, only buy more bonds if they are compensated with cash flows. The result is that interest payments on existing debt must be balanced with the pace of new debt issuance.
The conclusion is simple: Treasury interest payments must equal the rate of new debt issuance. The deficit is currently growing at about 6%-7% of nominal GDP, so the bond rate must rise to 6%-7% to achieve balance. But remember, if the private sector grows fast enough, some of that money creation can be used to lower the bond rate.
OK, back to the Fed. In an environment where interest cash flow is king, what happens when the Fed lowers the interest rate on short-term Treasury bonds, where the Treasury is concentrated? Short-term interest payments fall sharply. So, what will the market do to maintain portfolio allocations? It will demand that long-term interest rates rise.
Therefore, the first effect of the Fed cutting rates is necessarily to push rates higher elsewhere to meet the cash flow needs of bondholders. So we are in a strange world where cutting rates cools the economy (which relies on long maturities) while raising rates stimulates it.
I fully expect the Fed to cut rates tomorrow, and I also expect the long end of the yield curve to continue to rise as bondholders demand returns on their portfolios. Counterintuitively, a recession will only make this problem worse because the private sector cannot naturally absorb these bond issuances. Conversely, a thriving economy will keep interest rates at reasonable levels.
I don't envy those who were just elected into this mess because I'm almost certain they have no idea what's going on. Everything will look good until it suddenly goes really bad.