The recent fiscal stimulus measures, particularly the $1.9 trillion American Rescue Plan Act, seem more like a cruel joke than effective policy. Financing such endeavors relies on a troubling foundation—an enormous deficit built upon staggering debt, all exacerbated by the debasement of the dollar.
The Federal Reserve’s extreme intervention in credit markets is essential to this scenario. Equally alarming is the Bureau of Labor Statistics’ glaring neglect of actual price inflation. Just this week, the consumer price index (CPI) ‘reporting’ indicated an increase of 0.4 percent in February and a rise of 1.7 percent over the past year.
The interplay between major credit market interventions and misleading inflation statistics is wreaking havoc in financial markets. Where should we begin unpacking this situation?
When you buy a Treasury note, you’re essentially lending money to the government for a designated period—ranging from 30 days to 30 years—at a fixed interest rate. Historically, the probability of default on these Treasuries has been negligible.
With the Federal Reserve’s backing, the federal government can always print more currency to settle its debts. However, this practice is fraught with its own dangers. Printing more dollars diminishes the value of existing currency. Consequently, while nominal returns might remain intact, the real returns—when adjusted for inflation—can plunge into negative territory.
In essence, inflation erodes the value of Treasuries for investors. To adapt to expectations of rising inflation, yields must increase. Yet, this leads to a new dilemma for long-term Treasury investors.
As Treasury yields climb, prices of Treasuries drop. Over the past eight months, we’ve observed the yield on the 10-Year Treasury note rise from 0.5 percent to over 1.54 percent—an increase of 104 basis points.
This puts Treasury investors at risk of significant losses. Additionally, as interest rates climb and borrowing costs escalate, multiple negative consequences ensue.
High-priced stocks lose their allure, and heightened borrowing expenses hinder over-leveraged corporations, state governments, municipalities, and even federal authorities from effectively managing their debt.
When interest rates rise, the fallout can be dramatic, often leading to financial crises. Consider historical examples like Long Term Capital Management in 1998 or Lehman Brothers in 2008. Additionally, there have been significant stock market drops, such as the famous Black Monday crash in 1987.
While many catastrophic events are widely recognized, we’ll revisit a less familiar incident that offers important lessons. With pension fund managers grappling with serious cash deficits, similar situations could soon unfold in various towns across America—perhaps even in your own community.
Leveraged Arbitrage
Robert Citron was passionate about his role as treasurer of Orange County, California. His wife, Terry, remarked:
“He can barely stand the weekend at home. He can’t wait to get back. I think he’d go crazy without that job.”
Perhaps Citron could have benefited from finding a hobby—like soap making, yo-yoing, or taxidermy—to distract himself from the pressures of his job. The residents he served would have been far better off.
If you haven’t heard of Robert Citron, he was a pivotal character in a significant financial fiasco. In 1994, at the age of 69, Citron, who had been the treasurer for Orange County for 25 years, oversaw a staggering loss of $1.64 billion of public funds. This event ultimately led to the largest municipal bankruptcy in U.S. history.
The catalyst for Citron’s impending disaster was a series of interest rate hikes initiated by Alan Greenspan. This occurred in a time when the Federal Reserve did not provide advanced notice about rate increases, unlike the current trend of announcing future hikes through various communications.
Citron had a track record of predicting market movements successfully and had become a well-respected figure in the investment community, consistently outperforming local investment pools by at least 2 percent. This reputation attracted numerous schools, cities, and districts eager to invest with him, often without investigating the methods behind his success.
His investment strategy hinged on a simple assumption: interest rates would stay low, creating arbitrage opportunities from the gap between short and long-term yields. To capitalize on this, he used structured notes and significantly leveraged his portfolio.
By employing reverse repurchase agreements, Citron borrowed against his securities to acquire more securities, expanding a $7 billion portfolio into an astounding $20 billion position.
Initially, Citron’s strategy flourished, yielding impressive returns as interest rates adhered to his predictions. However, when rates started to rise, the tide quickly turned against him.
In February 1994, the Fed began its rate hikes. Citron’s amplified gains soon morphed into catastrophic losses as the increasing rates took their toll, ultimately pushing the County into bankruptcy.
Fifty Basis Points to Disaster
Currently, Federal Reserve Chairman Jay Powell is advocating for a sustained period of inflation, indicating that the Fed plans to keep the federal funds rate close to zero until at least 2023.
But what if the credit market has other plans?
The yield on the 10-Year Treasury note has surged by 104 basis points over the past eight months. However, every trend can face a countertrend; it’s possible that in the coming month or two, we might see a decline in bond yields.
Nevertheless, the monumental expansion of money supply has already occurred, leading to escalating price inflation—whether or not the Bureau of Labor Statistics acknowledges it. Thus, there is a realistic possibility that the yield on the 10-Year Treasury note could increase by another 50 basis points this summer.
We hazard a guess that we are merely 50 basis points away from potential calamity.
The financial system, seduced by an endless influx of cheap credit from the Federal Reserve, has become dangerously leveraged. Just watch: once the yield on the 10-Year Treasury note surpasses 2.10 percent, we could witness financial upheaval across corporate debts, hedge funds, and pension funds.
The Fed aims to avoid such outcomes, seeking to promote inflation without pushing interest rates higher.
To that end, the central bank will likely expand its balance sheet—whatever is necessary—and purchase bonds with printed money to keep interest rates stable. The Fed is already injecting $80 billion monthly into Treasuries and $40 billion into mortgage-backed securities in a bid to suppress rates.
However, these asset purchases could escalate, further deepening the debt crisis and concurrently fostering a crisis for the dollar.
Reflecting on the 1994 Orange County incident, a grand jury investigation revealed that Citron relied “on a mail-order astrologer and psychic for interest rate predictions.”
Today, we have the Fed’s dot plots, which resemble astrology or psychic forecasts more than they do sound economic analysis. They have little relevance to the actual dynamics of inflation or a properly functioning credit market.
The stark reality is that we stand at a precarious threshold—50 basis points away from disaster. The Fed may attempt to stave off this impending crisis with increasingly substantial amounts of printed money, and it seems inevitable that they will resort to such measures. After all, it’s the only way to keep the government afloat.
However, one does not need to be overly imaginative to foresee where this path leads. If you have yet to invest in gold or silver, now may be the time to reconsider your options.
Sincerely,
MN Gordon
for Economic Prism
Return from Fifty Basis Points To Disaster to Economic Prism
