Why the Fed will change its exit strategy – substantiated

Capture

In Why the Fed will change its exit strategy…again we argued that the added net supply of TSY from the Federal Reserve over the next coming years will create problems for elevated markets as the reallocation of funds held by the private sector and corresponding higher interest rate will pop the bubble the Federal Reserve created in the first place.

In today’s missive we would like to substantiate this argument as some clueless commentators called it crap economics; as usual they did so without even attempting a rebuttal.

To reiterate; since the Federal government is running a deficit and is expected to do so for the foreseeable future, per Congressional Budget Office (CBO) and White House Budget forecasts, an end to the Federal Reserve reinvestment strategy means net supply to the private market must increase correspondingly.

The chart immediately below depicts the expected development in TSY issuance using CBO deficit projections along with Federal Reserve TSYs coming due.

Capture

During the financial crisis the Federal government ran annual deficits of more than a trillion dollars for four years straight, but the Federal Reserve absorbed a lot of the issuance, essentially funding the government. For example, in 2011 a deficit of $1.3 trillion was reduced to “only” $644 billion of net supply on the market as the central bank absorbed $656 billion worth of TSYs. In 2013 there were almost no net supply of TSYs due to 1) a lower deficit and 2) a continued expansion of the central bank balance sheet.

In addition to this, all interest paid to the Federal Reserve is reimbursed back to the US Treasury helping to improve the fiscal balance to the tune of $80 – 90 billion per year.

However, this development will be diametrically changed if the Federal Reserve goes along with its stated exit strategy. Per our blog post yesterday we know TSY maturity will be over $800 billion from now and up to 2018 which will add to the US “deficit.”

In, say, 2018 the primary deficit is expected to be only $130 billion or 0.6 per cent of GDP, but due to the massive debt load the total deficit, including interest expenses of over $400 billion and the Federal Reserve’s “supply” net issuance will be more than $900 billion.

As a matter of fact, the Federal government will be issuing close to a trillion dollar of new TSYs every year for the next 10 years.

And this projection takes into account relatively rosy projections from the CBO. As the next chart shows, incorporating the GDP forecast provided in the CBO data set, this will be the longest expansion, by far, ever recorded.Capture

It would be prudent to expect at least one recession during the next ten years, especially considering the fact that the current expansion, albeit slow, is already the third longest on record. As we will show in our next blog post, the US economy is already very fragile and could easily tip into recession before long. If that would happen, and the Federal government again is running trillion dollar primary deficits, there will be no end to reinvestments, but renewed effort to fund the government over the printing press.