The cost of capital is likely the most important input into the valuation of most assets. The monetary policy anchor is the U.S. Federal Reserve’s control of the Secured Overnight Financing Rate (SOFR, formerly LIBOR).
Just about everything in the risk asset world is somehow based off this very important cost of funds. The fiscal policy anchor has become the indebtedness of the U.S. economy and the forecasted deficits adding to net debt going forward.
The U.S. and other governments can issue as much debt as they want to buy votes and stimulate the economy. The mandate of the U.S. Treasury is to maintain an orderly market and to fund the debt at the lowest possible cost to the taxpayer. The caveat of course is at what cost does all that debt clear the market?
This is possibly U.S. Treasury Secretary Janet Yellen’s final quarterly refunding (QRA) this week. A Donald Trump White House would appoint a new secretary.
The base case estimate from the Treasury Borrowing Advisory Committee (TBAC) and some basic calculations is that the QRA need will be between US$500-$750 billion in new debt. The deficit is estimated to be about $545 billion plus buyback and runoff financing needs taking the total to $650 billion.
The most likely case if the need is $650 billion or lower is that there would be no pressure on Yellen to increase the bond auction sizes and the bond market would get some near-term relief.
It’s the increase in bond supply that has the biggest influence on the cost of money since the FOMC holds the money market anchor setting the SOFR/Fed Funds rate. And now that they are no longer buying longer-term debt and reducing it, the long end is at the mercy of the “free market” to set the price.
It seems unlikely that Yellen would want to upset the equity markets before the election and the variables that would see more bond supply needs will be pushed into 2025. But make no mistake, the need to fund more bonds is real and inevitable.
Part of the recent rise in yields is a bet by investors that Trump’s policies will require more bond debt funding and that they would do that early in the presidential cycle so they can blame it on the Democrats.
Andy Constan of Damped Springs Advisors is one of the top macro investors we follow. This chart is his estimate of funding needs and when the Treasury will need to increase the size of the bond supply (versus continuing to increase bills).
Historically, the mix of bonds and bills is 80:20. Since COVID-19 and the explosion in deficits, that ratio has been much higher in bills.
No matter who wins the election, deficits will increase going forward. Under a blue or red sweep, that’s the worst outcome for the bond market in 2025-26.
If we get a blue or red split, there will likely be less overall spending, so from a bond perspective, that would mean the least amount of supply pressure. We continue to believe that traditional fixed income investing in this era of massive debt and deficits along with less globalization make public bonds a bad relative bet in your portfolios.
Since Brexit, we’ve been telling BNN Bloomberg viewers that bonds are broken as a real return vehicle for the risk mitigation part of your balanced portfolios.
The real returns in the past decade after inflation have been tragic. There’s no other way to see it.
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