“Treasury intends to gradually increase coupon auction sizes”
Somewhat related to this week’s bond market turbulence, we’d like to bring your attention to a recent article in the WSJ by John Cochrane.
Looking in the rear-view mirror, Dr. Cochrane argues that the latest inflation episode “is a smashing confirmation of the fiscal theory of the price level” (which is admittedly Dr. Cochrane’s favorite hammer), explaining that the rise and fall of inflation was purely mechanical. “A one-time $5 trillion fiscal blowout causes a one-time rise in the level of prices… Then inflation stops, even if the Federal Reserve does nothing”. But the real meat comes when Dr. Cochrane starts to move his gaze to the side mirrors and even ahead. After pointing out that “greedflation” arguments are a typical response to sudden accelerations in inflation, “Witch hunts for ‘greed’, ‘price gouging’ and ‘monopoly’ have followed inflation for centuries. They too at best confuse relative prices for the level of all prices and wages.”, he deflates (forgive us) it as an underlying cause, “A supply shock can’t make the price of everything go up unless the government gives people enough money or debt to afford the higher prices.” Dr. Cochrane then flags the scale of the fiscal deficit as a problem, noting that “The U.S. is running a scandalous $1.5 trillion deficit with unemployment at 3.6% and no temporary crisis justifying such huge borrowing.” It is thus no coincidence that, “The Congressional Budget Office projects constantly growing deficits, and even its warnings assume nothing bad happens to drive another bout of borrowing.” We think Dr. C is perhaps overstating his case, but what intrigued us is that the WSJ decided to publish his concerns. And it’s not just Cochrane.
The trajectory of US fiscal policy has been noticed by the likes of Hank Paulson and Jim Geithner, who recently spoke about the US’s long-term fiscal challenges, saying, “our fiscal trajectory is concerning”. Even the St. Louis Fed joined in (E tu St. Louis?) with some research noting that “As a matter of arithmetic, the trends of US government debt and deficits will eventually result in an outrageously high government debt-to-GDP ratio”. The kicker? The article specifically looks at the potential for “fiscal dominance, which is the possibility that accumulating government debt and deficits can produce increases in inflation that “dominate central bank intentions to keep inflation low”. The piece ends with finger pointing “This problem seems likely, given the way Congress has behaved in recent years”. I, too, can’t believe that the teenagers drank the booze offered to them.
One of the key questions when considering fiscal policy is the question of debt dynamics or, to put it more prosaically, whether the dogs will keep eating the dog food. There may already be signs that the market is experiencing a touch of indigestion. The Treasury announced new, higher estimates of issuance in the coming quarter to more than $1 trillion of privately-held marketable borrowing, some “$274 billion higher than announced in May 2023”, “primarily due to a lower starting cash balance, a higher assumed end of quarter cash balance, and projections of lower receipts and higher outlays” aka deficit (note that receipts were down 11% YoY thanks in part to lower tax receipts, “elevated tax refunds, and lower Federal Reserve remittances” while outlays were up 10% YoY). And while the Treasury’s Borrowing Advisory Committee wrote that “the recent rapid increase in T-bill supply has been well absorbed”, the Committee was slightly dubious about the ability of the longer-end to absorb added supply and “felt that the 7 and 20y segments may not bear increases as well as other points on the curve”. Of course, it didn’t help that the Bank of Japan moved the band on the 10-year JGB up to 1% (but only to ensure its ongoing ability to do QQE and NIRP?). But the combination of all these factors may explain the heightened bond market turbulence we experienced. It’s hard to think there isn’t more of it in the pipeline.
“A downturn was apparent to anyone willing to notice it”
Which is probably not great news for either CRE or those who lend to it. We can add another real estate dumpster fire to our list, with multifamily looking decidedly rate-sensitive recently. Take, for example, this recent article on MF1 Capital, a debt fund that “originated at least $7.4 billion in debt between 2020 and 2021, giving high-leverage loans to multifamily syndicators looking to act on aggressive fix-and-flip plans”. Now, with a loan book of almost $11 billion, prevailing conditions mean “almost half of the deals are either watchlisted or delinquent”. As the article notes, “The focus for many borrowers and lenders is now on exit strategies.” “With multifamily valuations down by a fifth, distressed investors will be forced to evaluate whether the property is worth another cash infusion.” What’s more, “A rash of foreclosures will reset multifamily valuations, deterring sales by owners who bought at market highs.” The article notes that lenders are thus presented with three options: “Extend and pretend, take back the asset or sell the mortgage to a third party willing to do the dirty work of foreclosure”. Channeling the infamous WSB yolo artists, one economist is quoted as saying, “A lot of lenders are holding out as long as they can, because there’s no upside to selling at a loss now”. While he may be right (er, tax loss harvesting?), the sentiment seems to broadly take the first option of extend and pretend. After all, maybe Schrodinger’s cat isn’t dead.
