Monetary vs. Fiscal Dissonance

Monetary and fiscal authorities are currently running what we believe are unsustainably divergent policies.

The simultaneous rise in the cost of debt by central banks and their deliberate reduction of balance sheet assets is entirely incongruous with the exponential growth in government debt.

Following the COVID era, we have entered a period of fiscal dominance among major developed economies. Hence, the escalating debt burden is already near historical levels and compounding at an alarming pace.

To sustain the current government spending deluge, we believe it is inevitable that the Fed and other monetary authorities reassume their fundamental role as the primary financiers of government debt.

Quantitative tightening policies are the central banks’ own version of an illusionary “debt ceiling”, a disciplinary measure that needs to be consistently reversed in practice.

The primary emphasis of our research will be centered on the United States, which is now running twin deficits that are as severe as those experienced during the worst parts of the Global Financial Crisis.

This factor has contributed to the recent weakness in the US dollar.

However:

Of even greater concern is the indication that this represents an ongoing structural issue that is still in the process of evolving.

Note that with each prior recession, this measurement has reached new lows.?This further emphasizes the importance of owning hard assets in this environment.

The reality is that the fiscal agenda on a global scale has never been more expansive.

While today’s severe inequality and wealth-gap issues have led to larger government social programs compared to historical norms, rising geopolitical tensions further exacerbate the issue.

Countries acknowledge the significance of bolstering defense spending and the crucial need to reduce interdependence among trading partners by revitalizing domestic manufacturing capacities.

Alongside this trend of reindustrialization, particularly among G-7 economies, governments persist in advocating for a substantial green-energy revolution, which necessitates a significant infrastructure overhaul.

Indeed, in the US, the impact of such high levels of government expenditure is evident in the data.

Excluding tax receipts, which have declined to levels comparable to those seen during recessions, fiscal spending alone represents a substantial 25.4% of nominal GDP in the US.

That is higher than what we experienced after the global financial crisis or any other crisis in history outside of the Covid recession when the economy was in full lockdown. ?

While interest payments are growing exponentially, that still contributes to a relatively small % of the overall fiscal outlays.

To be specific, it accounts for less than 10% of it.

Interest payments used to be close to 15% of government spending in the 1980s and 1990s when interest rates were higher.

This number is set to undergo a substantial increase and has the potential to create a larger problem soon.?

Nonetheless, the US fiscal impulse has turned positive in a significant way recently, especially when calculating it excluding interest payments, which is now up 12% on a year-over-year basis.

A reminder:

In a healthy economic growth environment tax revenues typically increase while government spending tends to decline.

Today, we are experiencing a complete reversal of this trend.

The US is currently operating as if it were facing another pandemic lockdown from a fiscal spending and debt issuance perspective, yet there is one critical difference. Rather than the Fed financing over 50% of newly issued Treasuries, they are shrinking their balance sheet assets at the fastest pace in history.

It is important to consider that, unlike during the recovery from the global financial crisis, other central banks have not been buying?these government bonds either.

In fact, foreign holders currently own only approximately 20% of all outstanding Treasuries, marking the lowest level in nearly two decades.?

Following the resolution of the debt ceiling agreement, the US government has already issued more than $1 trillion worth of US Treasuries.

Notably, the month of June witnessed the second-largest issuance in history.?

Yes…

?As anticipated by the market, a significant portion of these issuances is comprised of T-Bills, which are short-term maturity instruments.

However, what seems to be off the radar is the fact that there has also been a substantial issuance of longer-duration Treasuries in recent months.

The significant increase in the overall supply of these sovereign instruments is exerting additional pressure on long-term yields, contributing to their ongoing rise.

To reiterate, although US interest payments represent less than 10% of the overall fiscal outlays, these obligations are likely to surge even further in the next couple of years.

Here is one main reason for that…

The US will need to refinance almost half of its national debt in less than 2 years. As a reminder, interest rates were at 0% just 15 months ago. ?

H/t Ronald Peter Stoeferle, CMT, CFTe, MSTA

More importantly:

If the government decides to reissue these maturing Treasuries in short-duration instruments, as it did recently after the debt ceiling agreement, these obligations will need to be rolled over at over 5% interest rates.

While the US government is shifting focus to boost military expenditures from historically depressed levels, the current interest payments on the Federal debt have already exceeded annual defense spending.

This is likely the initial stages of a trend, and if no solutions are implemented, other components of the fiscal agenda may soon be constrained by the escalating cost of debt.

The notion of an "improving" economy being linked to rising yields seems completely ludicrous. The US debt problem is not only at staggering levels but is also compounding at ~10% annually, while the Fed continues to shrink its Treasury holdings at a record pace.

What gives?

Based on the rate-of-change analysis, there has been a 17% decline in the Fed's holdings of US Treasuries. Interestingly, historical patterns suggest that similar balance sheet contractions have led the Fed to eventually reverse its policy.

Given the current magnitude of Treasury issuances flooding the market today, resulting in upward pressure on long-term yields, we believe that the "yield curve control" narrative will soon regain prominence.

This is likely to benefit tangible assets, particularly precious metals

Let’s not forget:

Investing in gold implies wagering on the notion that the debt problem will deteriorate further from its current state.

The 1940s period was a compelling historical analogy to today given the severity of the current debt problem.

However, there is one major distinction that is often ignored.

During that time, the US dollar was effectively tied to gold prices, making the metal an unfeasible investment alternative.

Today, with prices unpegged, it is highly probable that capital will divert away from Treasuries and flow into gold.

This becomes particularly crucial at a time when the government continues to issue a flood of debt instruments into the market.

Gold is likely to serve as an escape valve for those seeking the ultimate form of protection during times of debt and monetary crises.

If the rationale for owning Treasuries today is solely based on the premise that the system cannot endure much higher rates, then gold is a far superior choice.

A neutral asset with no counterparty risk that also carries centuries of history as a haven and monetary alternative.

To add:

Inflation also appears to be in a bottoming process.

Just as base effects played a crucial role in reducing inflation rates, we anticipate that the opposite effect is on the horizon, with CPI likely to reach a bottom in the near future.

Last week’s CPI report marked a significant milestone as it is the first time in 102 years that we have witnessed 12 consecutive months of declining CPI on a YoY basis.

The last time we experienced such a situation was in 1921 after the Spanish Flu, which marked the actual bottom for inflation rates at -15.8%.

Today, after the same monthly sequence of falling CPI, the rate is still positive and above the Fed’s target.

The overwhelming focus on the recent slowdown in inflation appears to be rooted in backward-looking analysis. In fact, since last week’s CPI report, oil has broken out, gold rallied back above $2,000, silver surged, and agricultural commodities appreciated substantially.

While the macro environment today differs from that of the 1970s or 1940s, a lesson from history remains: inflation tends to develop in waves.

We have recently witnessed the conclusion of the first wave and are likely in the process of reaching a bottom in the recent deceleration period, with a new upward trajectory underway.

The primary reason for this is the persistence of underlying structural issues that continue to drive inflation rates higher:

1) Wage-price spiral, particularly driven by low-income segments of our society

2) Ongoing supply constraints due to chronic underinvestment in natural resource industries

3) Irresponsible levels of government spending

4) Escalating deglobalization trends, which necessitate the revitalization of manufacturing capabilities in economies.

It is also worth highlighting:

Despite the strong potential for inflation rates to be in the process of bottoming out, the Eurodollar curve is currently pricing in the largest interest rate cuts in the history of the contract for the next year.

Investors are highly likely to be caught off guard as CPI starts to accelerate again, leading the US monetary authorities to maintain higher Fed funds rates for longer and even engage in additional rate hikes in the short turn.

After being down 45% from its recent highs, the risk/reward to buy oil today appears heavily skewed towards the upside.

Excluding the outlier event of the pandemic crisis, we can observe 2 types of pullbacks in oil prices over the past few decades:

• ?The GFC and the 2014 energy market meltdown resulted in an avg. decline of ~75% from peak to trough.
• During the tech bust, the decline was -50%.

In the current environment, we believe there are strong similarities to the early 2000s period, particularly in terms of historically depressed capital spending.

Despite the risk of a demand shock, which is already largely reflected in the current prices, in our view, oil supply remains incredibly tight with production still below pre-pandemic levels.

Unlike a year or two ago, the government has already depleted its strategic petroleum reserves to levels not seen since the 1980s.?

Silver looks ready to break through its decade-long resistance this month. One thing is likely to be true, if this is indeed the onset of a new gold cycle, none of us own enough silver.

We continue to see key signals of stagflationary times ahead, it is hard to be structurally bullish on the economy.

One critical example:

Almost the entire Treasury curve is inverted, despite the fact that yields across the board, short and long-term, have been increasing.

The tech bust and the GFC certainly didn't unfold in this manner.

During those times, it was the collapse of long-term yields that led to a surge in inversions.

Today's issue in the Treasury curve resembles prior stagflationary times with yields across all durations rising.

Meanwhile, the valuation of US equity markets continues to defy logic, with completely delusional fundamental multiples.

Since the market peaked, Nasdaq has been significantly impacted by the increase in interest rates.

Despite the continuous upward movement in 10-year yields, this correlation has been disrupted by the euphoria surrounding AI and, consequently, the surge in mega-cap tech companies.

Sooner or later, we believe the present value of long-duration businesses will reflect the ongoing rise in discount rates with irrationally exuberant investors bearing the brunt of the punishment.

Overall equity market valuations are completely out of line with an environment where the cost of capital for businesses remains on the rise, accompanied by an increasing risk of a severe economic downturn.

Let us not forget that monetary policy works with a lag, and the Fed has been tightening financial conditions for almost 16 months now.?

Lastly, for those chasing one part of the world where the price of businesses is cheap and opportunistic, Brazil looks to be an alternative.

As an important way of capitalizing on a potential commodities-long thesis, we believe resource-rich economies are likely to perform exceptionally well.

Rarely in history have Brazilian stocks been as cheap as they are today.??

What if I had told you a year ago that:

?? The Fed would implement the steepest rate-hike cycle in history

?? Oil would drop by 45% from its recent peak

?? The commodities equal-weighted index would correct by 26%

?? Lula would assume the presidency

Would you have guessed that Brazilian stocks would have outperformed every developed market since 2022?

Ibovespa continues to beat the S&P 500 year to date despite the AI euphoria.

Today's macro and fundamental reasons to own Brazilian equities are exceptional. Opportunities like these are rare, and when they arise, they are often overshadowed by skepticism.

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Hope you enjoyed this research piece.

If you would like to read more, check out our latest research letter:

https://www.crescat.net/monetary-vs-fiscal-dissonance/

Have a great weekend,

-- Tavi Costa