This analysis was published earlier this week in Asia Times’ Global Risk-Reward Monitor, a weekly survey of economic and geopolitical factors affecting markets.
Given our current state of information about the new administration’s intentions, we foresee a gradually deteriorating economic environment in 2025 with persistent high interest rates, higher than expected inflation, and weaker than expected earnings.
The Biden Administration bequeathed Donald Trump the largest-ever federal deficit (at 6.1% of GDP) in an economic expansion. The president-elect wants to renew his 2018 corporate tax cut at an estimated cost of $400 billion per year, and eliminate taxes on Social Security income at a cost of about $150 billion per year. That would raise the federal deficit, now at $1.7 trillion, by about a quarter, minus possible revenues from additional tariffs (which now bring in about $80 billion a year in revenue), and whatever cost savings his team can obtain from spending reductions.
What can’t go on forever won’t, according to Okun’s Law, and the United States can’t continue to run up the federal deficit indefinitely. But it can do so for the foreseeable future — at some cost. America doesn’t face a “Liz Truss moment,” as Swiss Re economist Jerome Jean Haegeli told the Wall Street Journal November 21, referring to the blowup of the UK bond market in October 2022 after the short-tenured prime minister proposed deep tax cuts. For the time being, the US can finance the Treasury’s borrowing requirement with domestic sources. But that comes at a steep cost, and the likelihood is that economic headwinds will stiffen during 2025.
Unlike the aftermath of the 2008 World Financial Crisis, when foreign central banks financed the surge in Treasury borrowing, US domestic financial institutions absorbed the bulk of post-Covid Treasury financing, with some help from foreign private investors and US households. The predominance of financial institutions in Treasury financing is clearer visually in terms of levels.
Banks can continue to buy Treasuries, but only if interest rates remain high. McKinsey calculated that without the rise in interest rates of the past two years, return on equity for large parts of the banking sector would be lower than the banks’ own cost of capital. This requires a brief explanation: The yield on medium-term Treasuries is roughly equal to the banks’ cost of borrowing from the central bank, which means that the deficit can’t be financed by the proverbial printing press. Deposits, though, cost much less than borrowed funds, and the Biden Administration’s massive fiscal boost of 2019-2020 unleashed a flood of deposits into the banking system. Deposits rose much faster than banks’ loans and leases, and were channeled into Treasuries.
That set in motion a vicious cycle. Federal subsidies ballooned the deficit, but a significant portion of those subsidies was recycled back into the Treasury securities that finance the deficit. The subsidies unleashed inflation, and the Federal Reserve raised interest rates, making Treasuries attractive for banks. Higher interest rates doubled the cost of servicing the federal debt, to $1 trillion last year from $500 million in 2020.
In short, the ballooning of Treasuries on bank balance sheets, the higher rate environment, the higher deficit due to doubled interest payments, and high inflation are all facets of the same problem.
What could go wrong?
For one thing, the surge in deposits that allowed the banks to buy Treasuries with cheap customer money stopped a year ago. To continue to finance the deficit, banks will have to earn a higher yield than they currently pay for overnight funds from the Federal Reserve. At present the secured overnight financing rate is higher than the yield of five-year Treasuries.
Banks can fund purchases of Treasury securities with cheap deposits, but not with expensive borrowings from the central bank. As we see in the chart below, the year-on-year change in commercial banks holdings of US Treasury and Agency securities tracks the year-on-year change in deposits.
Now that the flood of deposits generated by the surge in government spending of 2021-2022 has dried up, banks will only be able to continue funding the Treasury deficit if the spread widens between their cost of funds at the central bank and the yield on Treasury securities. One possibility, of course, is that the central bank could provide cheaper funding to the banks. That in effect would finance the Treasury deficit through the printing press, a dangerously inflationary move. Fed chair Jerome Powell won’t do this.
The other possibility is that medium-term Treasury yields must rise. Rising long-term interest rates, though, will suppress if not extinguish economic growth.
Alternatively, US households could stop consuming and buy a lot more government securities. American households save just 4.4% of their disposable income, or about $1 trillion a year. If households doubled that to $2 trillion a year, they could finance the deficit by themselves. But a sudden drop in consumption would imply a recession and lower tax revenues and a bigger deficit.
Accidents are always possible – for example, a major glitch in the multi-trillion market for short-term financing of government securities. As the Federal Reserve shrank its portfolio holdings of Treasuries, the illiquidity of the Treasury market (as measured by the bid-asked spreads of off-the-run Treasuries) worsened.
But it is unlikely that a liquidity seize-up would do any lasting damage. Central banks know how to respond to such situations; they simply buy whatever is offered until the market comes down.
The consequence of the expansion of US debt, high inflation, high Treasury rates and high debt service costs is likely to be gradual – a headwind, not a cyclone. This will hit US consumers the hardest.
After the Biden subsidies ran out, US consumers responded to high (and much higher than reported) inflation by borrowing on credit markets to maintain their level of consumption. Credit card debt rose sharply while the interest rate on revolving credit jumped to 22% from 14%. Total interest payments on revolving credit rose to nearly $250 billion last year from about $100 billion in 2020.
The tax cuts that Trump’s team has discussed don’t have supply-side effects. Extending the old corporate tax cut doesn’t change incentives to invest, and removing taxation of Social Security benefits won’t bring more 70-year-old into the workforce. Tariffs cannot help but increase prices, both for consumers and for production inputs. The US now imports more capital goods than it produces at home for domestic use, so higher tariffs on imported capital goods will tend to suppress investment.
