Last week in 2018: The State of the Bond Markets Part 1, we shared our fear for possible ramifications of the Fed's QE (quantitative easing) program that may foreshadow a policy mistake; the Fed will try to raise interest rates too far, too fast. As we delve into Part 2, it is reasonable to review the government's total debt and the overstimulated money supply in this country.
Part 2: The U.S. Economy and the Government's Total Debt Outstanding
As we move on from Part 1, perhaps it is prudent to review where the U.S. economy stands as well as to quantify the United States government’s total debt outstanding. At the end of 2017, the total amount of debt outstanding for the U.S. government was just shy of $20.5 trillion. The United States government currently has a trailing budget deficit of over $700 billion which is about 3.5% of our nominal GDP. This information is important because it means that the U.S. Treasury has to issue over $700 billion of new bonds just to finance 2018’s deficit. In the short term, the recently passed tax reform bill may exacerbate this deficit. The bottom line is that someone is going to have to buy $1 trillion or more in the open market in 2018. If the demand is not there for this $1 trillion financing need, then interest rates will need to rise to create the necessary demand.
The Overstimulated Monetary Base
Our money supply, or monetary base, is simply the total amount of currency in circulation plus commercial bank deposit reserves. Since the crisis, in addition to the Fed’s balance sheet quintupling, our monetary base has quadrupled from ~$850 billion to $3.6 trillion. These are two of the largest forms of monetary stimulus used by our government to prevent the Great Recession from becoming another Great Depression. We are grateful to have avoided another depression, but how do we get rid of the stimulus outlined above without sparking new unintended consequences?
Meanwhile, from 1/1/08 to 12/31/16, the U.S. economy (real GDP) has only grown 12.3% or at a 1.3% annualized rate1. In 2016 the U.S. economy had a record 11th straight year with real GDP growth less than 3%2. While the U.S. economy grew just over 3% during the second and third quarters of 2017, we wonder if the economy has grown enough to absorb the stimulus outlined below. Put simply, the monetary stimulus that has been injected into our economy is larger than anything tried before, and we are concerned that any hint of inflation may cause interest rates to rise rapidly due to this monetary stimulus leftover in the system.
We are not alone. The Fed was not the only central bank to stimulate the economy after the great recession. The chart below includes the Fed, the Bank of Japan, the European Central Bank, and the bank of England’s QE. As shown in the chart on the left below, by the end of the first quarter of 2017 the stimulus had peaked at approximately $1.7 trillion a month. Since then we have seen all four of these central banks reduce or end their QE programs. During 2018, the Central Banks are projecting that their new QE stimulus will drop from roughly $1 trillion a month to about half this amount.
The chart on the above right also shows the implementation of interest rate hikes and cuts of the top 10 developed market central banks. As you can see, the overwhelming trend of lower rates appears to have ended, and in 2017 all 10 of these central banks either increased or left their interest rates unchanged.
Why is this so important? Well, it has been a long time since bonds had a bear market. U.S. Interest rates peaked in the early 1980s and the long-term trend has been sloping down for ~37 years until the recent lows.
With investors and/or retirees used to such low rates, how will everyone react if interest rates start to increase?
