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A dangerous view is creeping into the markets that the US has already gone so far down the path of a debt compound trap that it dare not raise interest rates to control inflation.
The US Treasury has become acutely dependent on short-term funding from hedge funds, many tapping the $US8.3 trillion ($11.6 trillion) money market and some operating with up to 100 times leverage. The share of purchases coming from stable lenders, such as foreign central banks and sovereign wealth funds, has been drying up.
Steven Blitz, the chief US economist at TS Lombard, says the Federal Reserve cannot tighten hard without risking a chain reaction. Financing costs would “explode”.
“Raising rates today immediately impacts the cost of nearly 25 per cent of the federal debt, where issuance is growing fastest,” he said.
The US Treasury has to roll over $US6 trillion of debt every three months in an increasingly sceptical market, as well as issuing $US2 trillion of new debt annually to cover the worst structural deficit in US peacetime history.
Annual gross financing needs – the key warning metric watched by rating agencies and bond funds – was 26 per cent of GDP in 2010. The International Monetary Fund says the figure will reach 45 per cent this year and is on track for 60 per cent by the early 2030s on current policies. No great power has long endured at that sort of level.
Scott Bessent, the poacher-turned-gamekeeper now in charge of the US Treasury, has been concentrating ever more borrowing on short-term bills. It is a way to keep a lid on the spiralling interest cost of the US national debt, which has quadrupled to $US1 trillion in a decade, now exceeds the US defence budget and is fast heading towards uncharted waters above 4 per cent of GDP.
But trying to defer America’s fiscal reckoning by monkeying with debt instruments is the trick used by broken hegemons through the ages. It is a Faustian pact.
We know how worried Bessent is about soaring bond yields – approaching a two-decade high – by the way he intervened alongside Japan earlier this month to halt speculation against the yen. He activated an obscure mechanism known as the FIMA Repo Facility to let Japan pawn a chunk of its $US1.1 trillion of US Treasuries in exchange for dollar loans rather than selling these bonds on the open market.
He joined the action by mobilising the Treasury’s holding of euros, without first telling the European Central Bank – a shocking breakdown of central bank etiquette. All this screams desperation.
Hedge funds have become the marginal buyers of US debt, doubling their share to 9 per cent of total US Treasury purchases over the past four years. They have been borrowing with extreme leverage on the repo market – a core part of financial plumbing – in order to extract arbitrage gains.
Both the IMF and the Bank for International Settlements have warned that this structure is an accident waiting to happen. It amplified a spiral of forced selling and a near meltdown of the US Treasury market in the COVID panic of March 2020. The critical point is that the whole US financial and fiscal system has never been so sensitive to short-term interest rates.
Kevin Warsh, the untested new Fed chairman, faces an invidious choice. The indecent manner of his appointment degraded his credibility before he even started. Markets know that President Donald Trump persecuted his predecessor for refusing to cut rates and refusing to become the infamous Arthur Burns of our age. They also know that Warsh’s billionaire father-in-law is a close Trump confederate and a key author of the Greenland grab.
Warsh struggled to articulate a coherent intellectual argument after the most recent policy meeting for why he was not raising rates. He could not explain how he intends to bring stubborn US inflation back towards the 2 per cent target when it is clearly going the other way.
