Milton Friedman said to watch government spending! Boy, was he right. The government is spending like we are in a recession and little of it is hitting the real economy. Just look at the deficit, interest expense, and the reverse repo market keeling over.
When the reverse repo market experiences a drain, this typically significantly decreases the amount of cash available in the market. The government is draining it with all its deficit spending and will get worse as revenues start falling and interest payments rise. Simply put the Us government is draining excess cash in the system to fund unsustainable spending and when it runs out it will start draining money from the real economy and significantly curb growth.
A drain in the reverse repo market means there is a reduction in the supply of cash available in the market and can put upward pressure on rates. This is happening as the Fed is doing 75B a month of QT. Banks are on the receiving end of all that is wrong with the economy.
Banks, pension funds, and insurance companies are bloated with treasuries and MBS that have been crushed and forced to hold to maturity. Banks are also seeing continued deposit flights, higher costs, and capital requirements. You don’t want to be a bank today.
A significant drain in the reverse repo market can lead to market disturbances and disruptions. It can affect the functioning of the money market and short-term funding markets, potentially causing volatility and instability in financial markets.
If the drain continues at the current rate, reverse repo will be fully drained within 6 to 8 months. Then what? Is the government going to stop spending 25% of GDP? Will they stop running deficits at 6 to 7% of GDP? Very implausible during an election year. Hiccups, shutdowns, minor cuts of a few billion here or there sure but nothing big enough to move the needle.
So where is the money going to come from? I don’t know and neither does the Fed nor the government. Can they do QE? Sure but has that helped us hold the debt growth? So not sure that the Fed can do QE or banks that just got burned buying low-yield treasuries are going to risk getting fooled a second time and if they do QE then forget about fighting inflation.
There is a real risk we could be facing higher yields not just for longer but “even higher for even longer” and in the middle of a liquidity crisis that the Fed could do little about. Treasury might roll out in-force on and off-the-run operations, BTFP could explode, and more banks could go bankrupt while rates stay high.
So if pundits start saying “even higher for even longer” you know you heard it. 6%+10y is not out of the question.
Oh, and I am not even including the possibility of the BoJ abandoning YCC and sparking a crisis in markets. The soft landing narrative is becoming more plausibly implausible while a new higher rate regime is getting more plausibly plausible.
