The Fed, the Treasury, and the bond market

The Fed is meeting again on September 15-16. The odds are more than 60% that they will hike interest rates, while the odds of holding steady keep slipping. It makes no difference to me either way.

The Fed can only control the short end of the yield curve. Raising the Fed Funds rate will accomplish little when the main drivers of added inflation are tariffs and the price of oil. As for the country’s out-of-control spending, the debt and deficit are fiscal problems. Congress is responsible for government spending, and in this case, pressure from the White House. The President’s recent promise to give every American $5,000 if the GOP wins both houses of Congress in the mid-terms would add more than another $1 trillions to the spending he has already demanded.

If the economy is growing and unemployment is low, the Fed has little effective work it can do to lower inflation. The only thing they can accomplish by raising rates is to slow demand for goods and services by curtailing credit. I'm in the camp that there will be no rate hike in September and maybe even December.

What the Fed can do is work with the U.S. Treasury in accomplishing its goal—reducing the debt and deficit while maintaining growth. We know the longer end of the yield curve (10-20 and 30-year bonds) dictates economic growth. In these durations, companies and individuals borrow through mortgage rates, car loans, investments, etc.

The lower the interest rates on this kind of borrowing, the higher the economy's growth rate, the higher the tax revenue, and, theoretically, the more money there is to pay down the nation’s debt. Anything the Treasury could do to lower those long-term yields would encourage higher economic growth. Especially today, when artificial intelligence promises to be as much of a productivity benefit to society as was the industrial revolution.

Both Warsh and Bessent believe the country would benefit if their two organizations worked more closely together, especially at a time when Paulson’s ‘doom loop’ might be a real possibility. Investors are asking whether Chairman Warsh would be willing to support the Treasury in keeping long-term bond yields in check. And if so, how?

I would love to be a fly on the wall during those closed-door discussions between these two ex-hedge fund managers. The obvious answer would be for the Fed to buy more Treasury bonds, especially on the long end.

They have already increased their ownership of short-term maturities from $2,974 billion to $3,003 billion since December under the Fed’s Reserve Management Purchases program. Of course, it’s just a coincidence that the U.S. Treasury has raised $18.9 trillion in bond auctions this year, with a substantial portion of that in the same short-term categories.

The Fed insists this is not quantitative easing, but rather an open market operation in which the Fed injects reserves into the banking system through “permanent” asset purchases. Buying long-dated bonds would be a ‘horse of a different color,’ as the Wizard would say. Quantitative Easing (QT), as it is called, however, is usually implemented when the economy is declining and/or to prevent deflation—the opposite of the present situation in the U.S.

The astute reader will say that, under the present circumstances, the Fed’s use of QT would be just a hop, skip, and a jump away from printing money and monetizing our debt. And wouldn’t that be inflationary? Yes, unless it was considered an emergency done in combination with an effort to combat a ‘doom loop’ (a slowdown in the economy caused by a spike in long-term interest rates).

None of this is original. Indebted nations have used the same combination of monetary and fiscal policies repeatedly throughout history to reduce debt and avert bankruptcy. The lost decade of the Eighties in South America is an example of this kind of monetary policy maneuver, where a nation’s currency fell, making its outstanding debt worth much less than it otherwise would have been. In the end, countries inflated away their debt load. It worked and returned their economies to some semblance of growth.

The difference is the U.S. is the largest economy on earth. We are not an emerging market, although we've certainly been acting like one in recent years. As long as the U.S dollar remains the world’s reserve currency, we could probably get away with it. To do so, the global system requires a continuous supply of dollar liquidity and safe assets (Treasury securities). Recently, that has come under pressure through central banks' accumulation of gold, regional settlement arrangements, bilateral trade agreements outside the dollar system, and what seems to be a gradual reduction in the dollar’s share of global reserves. In another column, I will address the Trump administration's recent actions to combat those dangerous trends.

I am not expecting a devaluation shock; that would jeopardize the U.S. reserve status. Instead, I believe we have already entered a period of fiscal dominance. It is a system in which our huge debt remains manageable through increasing dependence on accommodative monetary policy and structurally compressed real yields’

The Treasury's debt purchases are a case in point. Initially, Secretary Bessent announced a doubling of Treasury bond purchases to $4 billion per month. On September 9th, that amount was increased to $6 billion. It was still a drop in the bucket, given the size of the U.S. Treasury market, and yields moved higher still. The rumored use of almost $1 trillion in the Treasury's general account for bond purchases may be necessary to convince bond vigilantes that Bessent is serious.

Bessent’s current support of the Japanese yen is another example of what we can expect going forward. In this case, when the Japanese yen weakens too much, as it has over the past few weeks, the Japanese government has historically sold some of its dollar holdings in U.S. Treasuries and used the proceeds to buy yen. Those sales would put added pressure on U.S. Treasury bond prices, which would force yields even higher.

To prevent this, Bessent has agreed to ‘loan’ dollars to Japan to buy its currency. He warned speculators that he was “the House’ meaning he is controlling that market for the yen. Of course, this is a way to devalue the dollar. It was no accident that his statement goosed the price of gold, crypto, and other commodities.

I expect this kind of fiscal dominance to widen further. You can also expect increased cooperation and coordination between the Fed and the Treasury. As such, future quantitative easing, interest rate cuts, and more action to cap long bond yields are almost assured as conditions allow.

Bill Schmick is a founding partner of Onota Partners, Inc., in the Berkshires. Bill’s forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners, Inc. None of his commentary is or should be considered investment advice. Direct your inquiries to his website at www.schmicksretiredinvestor.com. Investments in securities are not insured, protected, or guaranteed and may result in loss of income and/or principal.