2 years ago
In August, central bankers and economic pundits from around the world descended on Jackson, Wyo., to hear the keynote speech at the Federal Reserve’s annual symposium. In the days afterward, the world’s smartest economic brains were all focused on trying to interpret the most important word from the speech: “pain.”
Fed Chair Jerome Powell was sending one clear message to global money managers: The Fed is deadly serious about reducing inflation, the bank won’t back off and the results are going to hurt. Specifically, Powell promised that the Fed will continue to hike interest rates and keep them elevated until the bank has brought inflation down from over 8 percent, where it is now, to the Fed’s target of about 2 percent. This week, the Fed is expected to announce another large increase at its regular policy meeting.
These steady increases will almost certainly mean higher unemployment and weaker economic growth until inflation is fully tamed, Powell emphasized. “These are the unfortunate costs of reducing inflation,” he continued. “But a failure to restore price stability would mean far greater pain.”
In case anyone didn’t get the message, Powell invoked the name of Paul Volcker, the legendary former Fed chair who doubled interest rates and killed inflation back in the late 1970s. Volcker is famous in central banking circles for doing the very hard thing that no one wants to do but that’s necessary to break an out-of-control inflation cycle. Volcker’s bitter medicine killed the economy, drove unemployment above 10 percent and ushered in the worst banking crisis since the Great Depression. But it also ended inflation after years of unsuccessful attempts by the federal government to do so using every tool from wage and price controls to public campaigns against spending.
Powell is right about one thing: It is difficult to anticipate just how much pain will be unleashed by the coming waves of interest rate increases.
But the Volcker comparison elides an important fact: Volcker had it easy, in many ways, compared to Powell. The American financial system today is far more fragile than the one Volcker inherited, mostly because of an economy the Fed has dramatically remade in recent decades.
Over the last decade, the Fed has undertaken an unprecedented experiment in ultra-low interest rates and easy money. Investors, bankers and governments have all adapted to that new economy, taking on more debt and pouring more money into riskier investments. Now, a decade’s worth of these debts and investments are going to collide with a higher-rate world. It’s not going to be pretty.
The worst damage will likely come in the parts of the financial system that the Fed has distorted the most over its past decade of easy money experiments: federal debt, corporate debt and sovereign debt. No one knows where we’re headed, exactly, but we do know how these key parts of the economy got to be so volatile in the first place. Here’s how — and why each of them is likely to bring huge shocks to the economy over the coming months or years of inflation reduction.
The Federal Reserve fed the national debt. Now, that debt is about to become a lot more expensive, straining the government and possibly roiling the global financial system.
One of the most obvious, and potentially most dangerous, distorted markets is the one for U.S. debt.
When Volcker hiked interest rates in 1980, the total amount of U.S. government debt was only $907 billion, or about 30 percent the size of the total U.S. economy. Today, the U.S. debt stands at $28 trillion, or about 125 percent of the total U.S. economy, meaning that our debt is worth about 25 percent more than our economic output each year.
This matters for a simple reason. When the Fed tightens the money supply and raises interest rates, it inflicts pain on U.S. taxpayers who must pay interest on the nation’s debt. The higher the debt, the higher the pain.
It was the Fed’s own experiments that helped create all this national debt in the first place. The Fed did so through an experimental program called quantitative easing, or QE. The importance of QE can’t be overstated. Under this program, the Fed created about 9 trillion new dollars between 2008 and today. (To put that in perspective, the Fed created only about $1 trillion in its first 95 years of existence. So it has printed 900 years’ worth of money in a little over 10 years, when measured against its historic rate.) All that money was injected straight into the Wall Street banking system, pumping up the very markets, like stocks and bonds, that are now threatened by the Fed’s tightening.
Here’s how it worked: The Fed would call up a banker at a place like J.P. Morgan and ask to buy $8 billion in Treasury Bonds from the government. Only about 24 banks — including J.P. Morgan — can sell Treasury Bonds directly to the Fed because those banks had a special designation as a “primary dealer.” When the Fed buys $8 billion in Treasury Bonds from a primary dealer, it does so by creating 8 billion new dollars out of thin air. The dollars instantly appear inside a special account the banks have inside the Fed, called reserve accounts. The Fed repeated this transaction over and over again until it had created the trillions of new dollars inside Wall Street’s reserve accounts.
This buying spree had the secondary impact of pumping up the market for U.S. debt because it made it cheaper for the U.S. government to borrow money. It was simple supply and demand. Every time the United States went to market to sell bonds and raise money, the Fed was there as a buyer. In the year or so after the Covid pandemic began, there were periods when the Fed was buying the vast majority of U.S. debt being sold. This meant that the government didn’t have to offer to pay high interest rates to entice people to buy its debt; the Fed was always there to buy. This kept 10-year-Treasury interest rates historically low since 2009. During 2020, when the Fed was buying trillions in Treasurys, the rate was almost zero. It’s hard to overstate what a huge effect this had on the ability of the U.S. government to borrow money. By May of this year, the Fed owned 25 percent of all outstanding U.S. Treasury bonds. It owned 38 percent of all long-term Treasury bonds that mature in 10 or 30 years.
The abundance of cheap debt has helped Washington borrow record amounts of money to pull off a seemingly impossible fiscal trick: increasing spending each year while also cutting taxes. This means that the government has borrowed about as much money as it actually raised in taxes this year, making annual deficits a normal part of the budget rather than something done in times of emergency.
“We don't plan to pay it back gradually — we just don’t know when we’re going to pay it back,” said Maya MacGuineas, president of the Committee for a Responsible Federal Budget, which has been trying to restrain U.S. borrowing (with little success) for more than a decade.
Now, the opposite dynamic is taking effect. As the Fed raises rates, government borrowing gets expensive. All of this means the fastest growing part of the U.S. budget could be the line item to pay interest costs.
“Whether you’re a big government person who wants to spend a lot more, or a small government person who wants spending to come down, neither of those gets first claim to the dollar. The first claim on dollars is always interest payments,” MacGuineas said. “It’s absolutely going to crowd out other priorities.”
The U.S. Treasury has paid about $409 billion on gross interest costs to outside lenders since October 1, 2021, when the fiscal year began, and July, which is the most recent date available. That figure is more than twice as much the government paid so far this year for all education programs. The Treasury has paid even more in gross interest — $590 billion — to all lenders, including other government agencies that have bought bonds. That figure is about equal to all defense spending so far this year.
The Congressional Budget Office estimated this summer that those costs are going to balloon. Annual net interest payments for the U.S. government could reach $1.2 trillion by 2032, the CBO estimates, which is about 65 percent higher than the entire defense budget this year. But even that prediction seems optimistic. It’s based on the assumption that 10-year Treasury interest rates will average about 2.4 percent this year. They are already above 3 percent, and the Fed is expected to hike rates further this fall.
Interest costs are already rising rapidly.
“It’s explosive,” said Red Jahncke, president of the investment firm Townsend Group International. He has been monitoring the Treasury market and comparing it against expected interest rate levels as the Fed starts hiking. He thinks most people have underestimated how fast and severe the rising costs will be. The total gross interest costs to the U.S. government were basically flat in recent years as the Fed held rates near zero, hovering at about $550 billion. Jahncke calculates that that figure will hit $1.2 trillion with the next 18 months, which would amount to more than the government spends on either the Department of Defense or Medicare.
This means that the Fed’s tightening will push the United States closer to a dilemma that cheap debt has allowed it to avoid for years. The government will have to either raise taxes or cut spending to avoid more and more of its budget to simply paying interest costs.
There is also the risk that U.S. borrowing costs will rise quickly and in a disorderly way. That’s because the U.S. hasn’t truly tested global demand for Treasurys in recent years without the Fed standing by as a guaranteed buyer. There is reason to be concerned that the test results might not be pretty. The Treasury has already had a shockingly hard time finding buyers in a limited number of bond auctions over the last year and a half. In February of 2021, for example, the government tried to sell $62 billion worth of 7-year Treasurys and had the lowest number of interested buyers since the 2008. A recent Bank of America analyst report cited the increasing number of dysfunctional Treasury auctions like this one to be a major risk to the global financial system. The analysts seemed unusually urgent in their warnings about this risk.
“In our view, declining liquidity and (declining) resiliency of the Treasury market arguably poses one of the greatest threats to global financial stability today, potentially worse than the housing bubble of 2004-2007,” the analysts wrote.
The problem, these analysts wrote, is that Treasury market prices are used as an indispensable benchmark to price a wide variety of other interest rates. If the Treasury market seizes up, then other vital markets would seize up for companies, consumers and governments. There is also a chance that the U.S. government could default on its debt obligations if it couldn’t effectively auction its Treasury Bills.
“While this sounds like a bad science-fiction movie, it is unfortunately a real threat,” the report read.
The Federal Reserve created the conditions for corporate debt to swell. Now, many companies could struggle to make those payments.
Chris Senyek, an analyst with investment firm Wolfe Research, was worried about corporate debt even back in 2019, when the economy was growing, inflation was low and the unemployment rate was under 4 percent. Like many other analysts Senyek noticed the massive upswell in corporate borrowing during the decade of zero-percent interest and quantitative easing. In 2019, Senyek coauthored a research report that mixed boring-looking charts with terrifying phrases like “death spiral,” “forced selling” and “the next crisis.” Companies had taken on so much debt that they were highly vulnerable to even a slight downturn in the economy, which would render companies unable to make their interest payments. Companies that owed more on interest payments than they earned in profit were called “zombie companies.” Only the flow of easy money kept the zombies moving. If it ever dried up, they would collapse.
The Fed was largely responsible for this state of affairs. The central bank performed quantitative easing by purchasing Treasurys from the “primary dealer” banks, which meant that the Fed was paying those banks with newly created dollars to close the transactions. Again, that’s how the Fed makes new money — by depositing new dollars inside the reserve accounts of Wall Street’s primary dealers and then relying on those private banks to start distributing the money into the economy how they see fit. After so many rounds of QE, trillions of new dollars had to look for a place to go. The money couldn’t be safely invested in Treasury bonds because Treasury interest rates were so low they didn’t provide much “yield,” or profit. So pension funds, hedge funds and private equity firms began shifting their money into riskier markets in a search for yield. This created the boom in corporate debt markets for leveraged loans (which are like corporate bonds, but individually tailored to each borrower, rather than standardized and sold on exchanges like bonds) and junk bonds (which are just corporate bonds that are rated as the riskiest and most likely to default). Between 2010 and 2020, the total amount of corporate debt almost doubled from roughly $6 trillion to $11.5 trillion.
Even Powell knew this posed a risk to the financial system. He warned about it when he first joined the central bank in 2012. He worried that the Fed was pumping up corporate debt markets so high that they would almost inevitably crash, creating a “large and dynamic” correction that the Fed would have to clean up, presumably through bailouts.
This is exactly what Senyek worried about in 2019: That an overheated debt bubble might burst if economic growth slowed. A few months after his paper was published, the first cases of Covid-19 were reported in Wuhan, China. The large and dynamic event began to unfold. During the Covid crash, junk debt-laden retailers, airlines, cruise ships and movie theaters had to close their doors simultaneously and couldn’t make their interest payments.
The Fed responded with a bailout of corporate junk debt markets that was so aggressive it even surprised the most grizzled of veteran junk bond traders. The central bank, for the first time, directly purchased junk bonds using newly created dollars. This propped up the market by ensuring that the Fed would step in as a buyer with unlimited money, making sure that prices wouldn’t crash if panicking bond owners all tried to sell their junk bonds at the same time. This kind of panic-selling was just beginning, but the promise of unlimited Fed buying calmed things down almost immediately. The junk debt market didn’t just recover but started hitting new highs when traders realized that the Fed’s money would act as their safety net. Total corporate debt rose from $11.5 trillion in 2020 to the new record high of $12.6 trillion today. The zombie continued their march.
Now, Senyek is worried again.
“I think we’re going to have a nasty corporate default cycle,” he said. “Higher rates will create a lot of pain … the borrower you might have lent money to when interest rates were close to zero is a different credit profile today.”
Corporate debt is particularly vulnerable to high interest rates because of the way its structured. Corporate bonds aren’t like credit card debt or home loans, which let borrowers pay down a bit of the loan’s principal each month. Instead, a corporate borrower only pays the interest costs on the bond until the date when the whole loan amount is due. At that moment, the company needs to either pay off the entire loan amount or replace it with a new loan. Most companies choose to replace their debt — or “roll” it, as they say — by selling the bond right before its due and borrowing a new bond to replace it. This works great as long as interest rates stay low. But when rates rise, the companies are faced with a terrible dilemma. They can either pay off their entire loan, or roll it into new debt at much more expensive rates.
All those companies straining under loads of junk debt are now discovering how exquisitely vulnerable they are to higher rates, which make their borrowing costs much more expensive. Debt defaults have already begun to rise for some forms of corporate debt.
Senyek is particularly worried about the riskiest form of investment-grade corporate debt, which carries a “BBB” rating. This debt is one downgrade away from being junk. If that downgrade happens, many investment funds will need to sell the debt because they are only allowed to own investment-grade debt, not junk debt. Back in 2011, only about 36 percent of investment-grade debt carried this BBB rating. Now, nearly 50 percent carries the rating, according to Wolfe Research. If the debt is downgraded, the resulting selloff could spark a massive downturn in corporate debt values.
This is the kind of ugly market correction that won’t stay confined to Wall Street. A slow rolling wave of defaults across the junk debt-laden country would likely mean more bankruptcies, more job losses, and maybe lower wages on the other side of things.
Because of Fed policies, developing countries became heavily reliant on foreign lenders. With higher interest rates, those lenders are likely to pull out.
When the Fed opened up the spigots of quantitative easing cash, much of the money flowed from Wall Street to the developing world. Under normal conditions, developing nations often have to pay higher interest rates to borrow money. But in the age of easy money, they had to pay less because so many lenders were lining up to buy their debt — again, interest rates were so low for Treasury bonds that they didn’t hold any appeal for international investors — and enjoy the high yield it would provide. This happened in the same way that the “search for yield” drove trillions of dollars into riskier debt like corporate junk bonds. This time, though, the riskier borrowers were sovereign governments in nations like Sri Lanka, Zambia, Turkey or Argentina.
Now, as the Fed tightens, that dynamic is reversing.
“When the U.S. raises interest rates, capital flows to the U.S. because the U.S. Treasuries are basically risk-free assets. And those are going to be paying more — interest rates are high,” said Marcello Estevão, Global Director of Macroeconomics, Trade and Investment at the World Bank. “That means that capital leaves somewhere. And that somewhere tends to be emerging markets and undeveloped countries.”
The timing couldn’t be worse. Inflation is already hurting poor and middle-class people in these countries. The pressure has only been intensified by Russia’s invasion of Ukraine and the resulting spike in energy prices. At the same time, economic growth is starting to slow, which could hinder these nations’ ability to pay their debt or afford more expensive staples like food and fuel.
The most vulnerable nations are already tipping into crisis. In Sri Lanka, the debt-laden government faced shortages of food and fuel and massive street protests that forced the president to temporarily flee the nation while the government arranged a $2.9 billion bailout from the International Monetary Fund. Zambia, which quadrupled its debt between 2014 and 2019, also had to get a loan from the IMF and has been asking its Chinese creditors to provide about $8 billion in debt relief. Zambia, like other nations in a debt crisis, is being forced to cut its services and social spending, increasing the hardship of its poorest residents.
These countries will almost certainly be only the first to fail. Estevão has predicted that we will soon see the worst spate of debt crises in a generation unfold across the developing world. He estimated that as many as a dozen countries will be unable to meet their debt payments over the next year.
Virtually everyone would rather avoid turmoil in the markets for U.S. debt, corporate debt and the debt of sovereign nations. But it appears that the threat of inflation will push Powell to inflict at least some level of pain to dampen price increases before they can spiral out of control. The best of all scenarios might be a surprising drop in inflation, which could give the Fed some breathing room.
But that doesn’t appear to be in the cards, at least for now. The September inflation figures came in above expectations, at 8.3 percent, cementing the belief that Powell will continue tightening. The Dow Jones Industrial average fell nearly 1,300 points, or 4 percent, on the news — a good indication of how much pain most people are expecting to come next.
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