The September Effect says the stock market tends to slump after Labor Day. This year’s Effect would likely be triggered by the bond market.
JP Morgan CEO Jamie Dimon says the stock market is overvalued and overleveraged. In July, he said bonds were overvalued too, with10-year U.S. Treasury Notes yielding only 4.5%. Since then, it has hit 4.75%.
Stock prices are based on prevailing U.S Treasury rates used to discount future company earnings; the higher the rate, the lower stocks’ value. Also, Treasuries are competitive investments; the higher their yield, the more attractive they become – to a point.
Dimon’s remarks are concerning. So are recent statements by other prominent figures in the world of finance.
Last April, former U.S. Treasury Secretary Hank Paulson issued a dire warning. He said that Uncle Sam needs a “break-the-glass emergency plan” for a coming national fiscal-financial crisis. He worries that, past a certain point, market demand for Treasuries, may disappear, leaving “the Fed the only buyer.” In essence, Paulson warned of a “doom loop,” or vicious cycle from which there is no escape.
The doom loop goes like this: seeing elevated risk in the nation’s yawning deficits and mounting debt and interest cost, buyers demand higher rates to buy the new Treasuries needed to finance the deficit; the new higher-rate Treasury debt widens the deficit and buyers demand even higher rates in the next cycle. And so on, until debt, deficits and interest costs are so high that nervous buyers refuse to buy, leaving the Federal Reserve Bank the only buyer.
Previous warnings have not spurred action. No one wants to endure the pain of reduced spending and higher taxes. Yet, the ultimate pain only grows the longer things are ignored - if a solution is even possible? Recently, Ray Dalio, founder of the nation’s largest hedge fund, said “we’ve passed the point of no return.”
Four years ago in September 2022, net Treasury debt was $24 trillion. In this June’s Monthly Treasury Statement, it stood at $32 trillion, a one-third increase in about four years. Net interest cost has grown even more. That’s of greater concern, because we have to pay interest. In fiscal 2022, it was $475 billion. Since then, it has more than doubled, reaching $1.1 trillion, or one-seventh of total spending over the last twelve months.
Now, where are things headed?
The average (“embedded”) interest rate on outstanding Treasuries has risen. We are no longer in the low-rate decade of the “teens” or the zero-rate COVID era. Net interest of $475 billion on $24 trillion of debt in 2022 implied an embedded rate of about 2.0%. Net interest of $1.1 trillion on today’s $32 trillion implies an embedded rate of about 3.4%.
Today, the entire Treasury yield curve is above the embedded rate. So, interest costs are definitely going up on existing debt. How much, how soon?
The Fed is expected to raise short-term rates at least by 0.25% by December, which would increase next fiscal year’s interest cost by about $17 billion on the $6.7 trillion of outstanding short-term T-Bills.
We have $16.3 trillion of outstanding 2-to-10-year T-Notes. About $2.9 trillion, with a weighted average rate of 2.95% and a weighted average maturity of 4.5 years will roll over in the next twelve months. At the current 4.5-year Treasury yield of 4.45%, that would increase annualized interest costs by $16 billion.
The repricing of teens-decade and COVID-era Treasuries with higher rates will continue for several years, and growing deficits will require new debt. And more interest cost. In a recession, rates would decline but massively more new borrowing would be needed to replace plummeting income tax revenue and to fund stimulus.
That’s a dire base case, and it assumes all else stays the same.
Yet, other things are not the same. Social Security and health entitlement costs continue to soar – up about $167 billion over the last year. The Administration wants about $450 billion more for the Pentagon in next year’s budget. While that increase is deferred through early December in the continuing resolution to fund the government at current spending levels, there is also a pending supplemental spending bill for $95 billion mostly for the Iran War.
Who will buy this fast-growing supply. Foreign buyers? Of the $12 trillion increase in Treasury debt over the last four years, foreigners have bought just $1.5 trillion. The biggest holders, Japan and China, have reduced holdings by about $450 billion combined.
Recently, the U.S. Treasury loaned dollars to Japan to buy yen to halt a slide in its currency. This was highly unusual. We acted to prevent Japan from selling Treasuries to support its currency. Why are we so nervous about Japan selling Treasuries?
The chickens could begin to come home to roost in September. We should heed the warnings of Paulson, Dimon and Dalio. They aren’t doomsday voices on the fringe. It is time to raise taxes and cut spending.
Red Jahncke is a nationally recognized columnist, who writes about politics and policy. His columns appear in numerous national publications, such as The Wall Street Journal, Bloomberg, USA Today, The Hill, Issues & Insights and National Review as well as many Connecticut newspapers.
