There are times when relying on a system to function as anticipated is so critical, where the prospect of failure is so outlandish, that the effectiveness of the system must be taken for granted before we would ever choose to engage it. The brakes on a car, the landing gear on an airplane; these things must function exactly as expected simply because malfunction would lead to immediate catastrophe.
For the last 50 years the U.S. federal government has spent a lot more money than it takes in. When the government spends more than its revenue, like any other company or family, it must borrow the money from someone else. The government borrows the money from institutional investors such as other governments, pension funds, insurance companies and mostly from banks. The system of how this money is borrowed is called the U.S. Treasury market.
The U.S. Treasury market is $27 trillion huge (source: Wall Street Journal), and it functions very specifically. When the government needs to borrow money the U.S. Treasury issues bonds. These bonds are offered to a network of large banks called primary dealers. These primary dealers buy the bonds. Some bonds, the banks hold for themselves, but most are resold to other institutional investors. While these banks are obligated to buy the bonds offered by the government, they are will willing to do so because they are confident they will be able to resell many to other investors.
The bonds in the Treasury markets are constantly maturing and being paid off, often with new borrowing, in a continual cycle of maturity and refinancing. Since the 2008 financial crisis, as bonds matured, new bonds were issued, mostly at much lower interest rates than the maturing bonds, lowering the cost for the government to continue borrowing more money.
Perhaps most importantly, however, since March 2009 the biggest bank of all, the Federal Reserve (the Fed) has been buying bonds resold from the primary dealer banks. Because of this near constant presence of the Fed as a strong buyer, over the past 14 years the primary dealers have come to take for granted the Fed would buy a good chunk of the bonds issued by the government, which made them more willing to buy up all the bonds the government offered.
We should all know by now; the Fed was buying these U.S. Treasury bonds from the primary dealers with new money it was creating for this purpose in a process called quantitative easing. This new money increased the supply of money available in the markets, and more money in markets usually makes markets function more smoothly. Smoother functioning markets are believed to have proved more resilient during the two major crises of the past 14 years — the financial crisis and COVID — helping, it is believed, our economy to avoid a major crash.
After many years the U.S. Treasury market got very used to the Fed as the constant buyer, to the point where the government as the bond seller felt emboldened to accelerate its borrowing, selling even more bonds, and the primary dealers felt confident buying all the bonds the government was selling, knowing it could resell some to the Fed. What could go wrong?
Well, unfortunately all this new money ended up contributing to the cycle of inflation being experienced right now in our economy. Inflation is very dangerous to an economy, and in an attempt to address it, five months ago the Fed decided it should no longer create the new money contributing to the issue, and it stopped buying Treasury bonds from the primary dealers, leaving a huge hole in the Treasury market process. After months of not having the Fed as a constant buyer of the new Treasury bonds, the primary market dealers appear to have become concerned about their ability to resell all the bonds the government is selling. This reticence is being called liquidity stress, and it is very important to understand.
For the financial system to function, like brakes on a car or landing gear on an airplane, the U.S. Treasury market must operate smoothly. In 2023 a large amount of U.S. government bonds mature and must be refinanced, and unfortunately in addition the government seems completely unable to step back the amount of new bonds it needs to issue to fund more and more spending. Without the Fed there to buy these bonds, questions are rising about how the U.S. Treasury market is going to navigate this challenge.
This week we experienced a contentious federal election. Issues such as abortion, protections for trans people, free speech, election integrity and many others were vigorously debated. These issues will need to be worked out over time, but over the next two years the most important issue facing our country might just boil down to math. The government simply needs to refinance too many bonds and borrow too much money, and without the Fed there as a buyer to facilitate this process, I for one am becoming concerned about the consequences. Also, unfortunately this is one issue I didn’t hear vigorously debated during the campaign cycle. Perhaps it should have been.
The economic forecasts set forth in this material may not develop as predicted.
The opinions expressed in this material do not necessarily reflect the views of LPL Financial.
Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com.
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