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The bond market is facing a serious challenge right now: too many bonds are being issued without enough buyers to purchase them.

This means that the U.S. government debt is not trading smoothly but rather like a low-value and high-risk stock. This dysfunctional trading environment should worsen exponentially by the end of Q1 2024. The Federal government owes $33.5T and has paid $712b in interest this year alone. This interest cost will increase sharply in the next few years as the government has to borrow more at higher interest rates. Interest payments are already 17% of all Federal revenue and could quickly rise to 35% soon. The deficits will be much more significant when the recession arrives, as the automatic economic stabilisers kick in, just as revenue collapses.
 

Entitlements and debt service payments will equal 100% of all revenue by 2040 at the very latest. At that point, there will be no room for any other government spending. Our bond market is fracturing, becoming an existential crisis for our financial system. What else would you expect when the nation’s annual deficit is 45% of our revenue, which adds to the national debt each year, an incredible 771% of federal yearly income?
 

THE FED AND THE BOND MARKET

I have explained why long-duration bonds have been a no-touch for several months. This is because China and Japan sell their U.S. Treasury holdings to prop up their currencies. Japan is also easing its policy of keeping long-term interest rates low, which increases the relative attractiveness of JGBs over U.S. bonds. Disinflation is being replaced by reflation, and the Atlanta Fed’s incredible 5% prediction for Q3 GDP puts more upward pressure on yields and keeps potential buyers at bay.
 

The big shock is that this instability is occurring while there is still $1.2 trillion in the Fed’s Reverse Repo (RRP) facility. Banks first parked their excess reserves, which resulted from the massive COVID stimulus packages from the Treasury, at the Fed to earn risk-free interest. That figure reached a high of $2.5 trillion in December of 2022. However, in the last five months, the amount in the RRP has crashed by over $1 trillion. This is, in essence, funding the Fed’s Q.T. program. If the current pace of RRP selling continues, the number of excess reserves parked at the Fed will be near zero by March of 2024. It will be at that point that much of the liquidity in the bond market will have disappeared.
 

One of the main reasons for the turmoil in the bond market right now is the excessive supply issuance, which stems from our unsustainable debt and deficits and the lack of foreign buyers. In fact, they have turned into sellers of our debt. The situation could worsen in the next few months when this vital source of easy Treasury liquidity dries up.
 

There are only two ways to save us from the coming bond market collapse possibly. The first is an immediate and complete restructuring of Social Security, Medicare, Medicaid, and Defense, including humongous cuts in benefits across the board. This will be as easy for Congress to accomplish as a camel going through the eye of a needle. And if the impossible does occur, the resulting recession would be so catastrophic that it might render the nation insolvent anyway.
 

The other temporary salve would be if the delayed recession were to occur imminently. That would send investors scurrying out of equities and into the relative safety of U.S. bonds. However, again, the resulting amount of red ink from the election of the automatic economic stabilizers would send deficits and debt skyrocketing from their already untenable $2 trillion level. The previous two economic downturns saw the yearly budget shortfalls more than triple. This means the U.S. would face an inevitable fiscal crisis, as the annual deficit could soar to $6 trillion, or an astonishing nearly a quarter of the entire GDP.
 

In the same month, the RRP facility runs out, the $100 billion in distressed bank assets currently decaying in the Bank Term Funding Program are scheduled to return to these financial institutions at a fraction of par value. Banks must then give the Fed 100 cents on the dollar plus accrued interest. Remember that these impaired assets threatened to render the entire regional banking sector insolvent at the start of this year. These Treasuries, MBS, and corporate bonds are even further underwater than when Mr. Powell first allowed them to be parked at the Fed. Oh, and by the way, March of next year will also be when the full-lagged effects of 500bps in monetary tightening begin to have their most significant impact.
 

Hence, within the next five months, the bond market should descend into complete chaos, and the Fed will be forced to end Q.T., start cutting interest rates towards the zero bound, and venture back into Q.E. once again. The stagflationary implications of all this will be staggering, especially since no investor will be conned into believing the Fed can adroitly fight inflation without paralyzing the banking system and the economy and risking a sovereign U.S. debt crisis.
 

PROBLEMS ON THE HORIZON

The situation is dire for many small businesses in the U.S. A recent report by Bank of America revealed that almost 30% of the firms in the Russell 2000 index are losing money. These firms rely on cheap credit to survive, but the cost of borrowing has more than doubled since 2021. They used to pay less than 4% interest on their loans, but now they have to pay 9.3%. This puts their future at risk and could have a negative impact on the stock market. This existential crisis is for 33% of small businesses, the engine of employment growth. Therefore, the labor market should begin to fracture by early 2024. A spiking unemployment rate will cause the real estate market to endure the same dire fate as the bond and stock market.
 

There is still some money to be made in the overall market until the end of Q1 2024 arrives. However, this is especially crucial for the 60/40 portfolio bag holders; you better identify when the freezing of the debt markets is about to arrive because securities could get wiped out across the board.
 

The swings between inflation and deflation will become more violent and destructive over time. Active and intelligent management is the best hope to survive and thrive in this chaos.

As always, we Pray for peace and try to love people as ourselves—this is how we prove our love for God is real.   EG

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