U.S. Treasury Faces Imminent Financing Crisis

January 8, 2022 is the 188th anniversary of the only day in U.S. history that the national debt stood at zero. As of December 21, 2022 it totaled $31.4T or about $94K per person in the nation.

A majority of people now believe federal government spending is out of control due to profligacy of elected officials who shower money on constituents and pet projects in unrelenting efforts to get re-elected. The prevailing view is the annual fight over raising the supposed national debt limit is a charade; and, there is nothing to prevent Congress from continuing its excessive spending.

Instead of focusing on federal expenditures and revenues, this article focuses on financing the national debt. Particular attention is paid to traditional owners of U.S. Government securities and the debt issuance problem the U.S. Treasury faces today.

Federal Budget

The U.S. Government’s fiscal year-end is September 30th. In 1974 and prior years it ended on June 30th, but The Congressional Budget and Impoundment Control Act made the change to allow Congress more time to agree upon a budget each year.

The federal budget can be considered a cash flow statement showing cash expenditures and cash receipts. The U.S. Treasury has a checking account at the Federal Reserve into which it deposits revenue and writes checks. To prevent writing hot checks, the U.S. Treasury needs to replenish its checking account with the Federal Reserve when there is a shortage of cash in its account. It does so by issuing Treasury debt securities and depositing the cash received into its checking account at the Federal Reserve. If there were no timing differences and no cash in its checking account, the amount of U.S. Treasury debt outstanding would increase by the amount of the federal deficit.

Column 2 of Exhibit 1 shows 2001 was the last year the United States had a federal budget surplus. The nation has now run deficits for 21 consecutive fiscal years totaling $19.1T. Of that total, the last three years accounted for $7.3T (38.2%) of the deficits.

There is no relief in sight for persistent federal deficits. Exhibit 2 shows the official Office of Management and Budget “OMB” forecast is for an estimated deficit of $1.154T for fiscal 2023.

Size of U.S. Treasury Debt

Persistent budget deficits necessitated a significant increase in the debt issuance by the U.S. Treasury. Column 3 of Exhibit 1 shows total national debt outstanding at fiscal year-ends for 2001-2022, and column 4 shows the amount of debt issued during each fiscal year. Exhibit 1 shows the U.S. Treasury had to issue $25.1T in securities during the 21 fiscal years ended September 30, 2022. In the last three years alone, the government had to issue $8.5T in additional debt.

For the 21 fiscal years ending in 2022, Treasury debt grew at a compound annual rate of 8.3%. During the same span, GNP grew at a compound annual rate of only 4.3%. The ratio of debt a GDP, therefore, increased from 54% to 120%.

Types of U.S. Treasury Debt

The U.S. Treasury issues marketable as well as nonmarketable debt to the public. Marketable debt includes bills, notes, bonds, inflation protected securities “TIPS” and floating rate notes “FRN.”

On September 30, 2022 the public owned $23.7T in marketable Treasury securities. Bill totaled $3.6T or 15.4% of the total, notes $13.7T (57.9%), bonds $3.9T (16.3%), TIPS $1.8T (7.8%), and FRNs $0.6T (2.6%).

The nonmarketable securities issued by the Treasury totaled only $626B at 2022 fiscal year-end. These securities do not trade and are redeemable only at the U.S. Treasury. Nonmarketable securities primarily include Series E, EE, H, HH, I Savings Bonds and State and Local Government Series instruments issued to avoid arbitrage in refundings.

Maturity of Marketable Public Debt

At the end of September 2022, $5.5T or 23.2% of the Treasury’s marketable securities matured within one year. The average maturity of marketable debt was 68 months. The Federal Reserve owned $1.2T of the $5.5T U.S. Treasury securities maturing within a year.

Ownership of U.S. Treasury Debt

At the end of fiscal 2022, foreigners were the largest owners of U.S Treasury securities. They owned $7.3T or 23.7% of the $30.9T outstanding Treasury debt. Official foreign entities (primarily central banks) owned $3.7T, while other foreigners owned $3.6T.

The second largest owners of Treasury debt were intragovernmental agencies, primarily the Social Security Administration. They owned $6.6T or 21.3% of the outstanding debt.

The third largest owner of Treasury debt was the Federal Reserve. It owned $5.7T or 18.4% of the Treasury’s total debt.

Other owners included mutual funds at $2.8T or 9.1% of total debt, banks and other saving institutions at $1.8T or5.8%, state and local governments at $1.5T or 5.0%, pension funds at $1.1B or 3.6%, insurance companies at $0.4T or 1.3%, and unidentified others at $2.9T or 9.3%.

Interest Rate on U.S. Treasury Debt

As of September 30, 2022 the average interest rate being paid by the U.S. Treasury on its $23.7T in marketable debt was 1.994%. On bills the average rate was 2.453%, notes 1.59%, bonds 3.001%, TIPS 0.464%, and FRNs 3.309%.

On the $0.6T in nonmarketable debt the average interest rate was 2.342%. The average rate being paid by the U.S. Treasury on its total debt held by the public was 2.07%.

Exhibit 2 shows the average rate paid by the U.S. Treasury on its public debt on September 30th from 2013 through 2022. It shows the rate ranged from a high of 2.494% in 2018 to a low of 1.605% in 2021.

The increase in interest rates since the Federal Reserve started raising rates in March 2022 has been breathtaking. The total return on fixed income securities in 2022 will be the worst in the history of the United States.

The Federal Reserve knows that the average depreciation in investment portfolios of insured banks in the United Stated amounted to about 29% of their equity capital on September 30, 2022. They also know that a number of these banks had investment portfolio depreciation exceeding their capital.

The Federal Reserve itself had unrealized depreciation of $687B or 11.7% in its U.S. Treasury portfolio and $438B or 15.9% in its MBS portfolio. The Fed, therefore, has total investment portfolio depreciation of $1.125T and that equaled a stunning 27x its September 30, 2022 equity capital of $41.847B.

Federal Reserve Aids and Abets

Congress has had a free rein to spend money and run deficits for the past 21 years. They put their profligacy on steroids from 2020 through 2022 as the federal government ran fiscal deficits that surely made President Andrew Jackson rollover in his grave. After all he was the President when the national debt was zero.

The ability of Congress to incur deficits is almost totally dependent on the U.S. Treasury’s ability to rollover existing debt and issue additional debt. In that regard, the U.S. Treasury is “on the clock.”

The recent surge in deficit spending was aided and abetted by a Federal Reserve that instituted a zero-interest rate policy (ZIRP) and distanced itself from traditional monetary theory as espoused by Milton Friedman and The Chicago School. The Fed, along with other central banks around the world, adopted a belief that the size of a central bank’s balance sheet could be significantly increased without collateral damage.

At the end of fiscal 2007 the Federal Reserve owned only $780B in U.S. Treasury securities. During the global financial crisis of 2008-2012, the federal government had combined deficits of $7.1T and the Federal Reserve added $999B to its U.S. Treasury holdings. The Fed, therefore, picked up only 14% of the Treasury’s tab!

The U.S. Treasury reliance on the Federal Reserve to finance its deficits increased dramatically during the 2020-2022 period. In those three years the government ran deficits totaling $7.3T and the Federal Reserve added $3.7T in U.S. Treasury securities. The increase in Fed holdings, therefore, equaled 50.7% of the additional debt issued by the U.S. Treasury.

In March 2022 the Federal Reserve belatedly moved to a less accommodative monetary policy to combat inflation. As a part of that policy, in June the Fed announced that beginning September 1, 2022 it would reduce its holdings of U.S. Treasury securities by $60B per month and mortgage backed securities “MBS” by $35B via roll offs.

Exhibit 3 shows actual runoffs for September 2022 through November 2022. The data suggest that the Fed, after a slow start in September, is on track to meet its runoff objectives. Fed Chairman Powell has said numerous times that the Fed has not sold any securities and has no intention of selling going forward.

Foreign Ownership of U.S. Treasury Securities

Countries with surpluses in their balance of payments with the United States accumulate U.S. dollars. Their surpluses are primarily due to their having favorable trade balances with the United States, whereby their exports to the U.S. exceed their imports from the U.S. These countries have traditionally invested a significant portion of their growing dollar surplus in the U.S. Treasury securities.

It was not until 2000 that foreign ownership of U.S. Treasuries reached $1T. By 2010 it reached $4.4T; and, as noted earlier, foreign ownership of U.S Treasury securities totaled $7.3T as of September 30, 2022.

Foreign official institution holdings are composed of $220B in U.S. Treasury bills and $3.5T in notes and bonds. The amounts of bills, notes, and bonds owned by non-official foreign holders are unknown.

Exhibit 4 shows the U.S. Treasury securities held by foreigners on September 30th of 2020-2022. It shows a pronounced decline of $450.7B in 2022 of which $32B was non-official and $418.7B was official.

Japan is the largest owner of U.S. Treasuries and in 2022 it reduced its holdings by $183.8B or 14.1%. China is the second largest owner and it reduced its holdings by $147.2B or 13.6% in 2022.

It is interesting to note that Russia in 2012 held 161.5B in U.S. Treasury securities. When its holdings were last reported in 2017, it held $13.2B.

Explanations for Japan reducing the size of its U.S. Treasury holdings include deterioration in its balance of trade and a need to support a weakening yen. To support the yen, the government buys yen with U.S. dollars. The Bank of Japan “BOJ” could avail itself of swap lines available at the Federal Reserve to get U.S. dollars instead of selling or allowing U.S. Treasuries to roll off.

The reasons for Russia and China reducing their holdings of U.S. Treasury securities undoubtedly have more to do with geopolitics. Why would any country lend money to a sworn enemy that has a penchant to impose harsh sanctions? Hatred of China and Russia seems to be one of the few beliefs that garners bipartisan support in Congress.

U.S. Treasury Crisis Is Here

The projected federal budget deficit for fiscal 2023 is $1.154T. It, however, significantly understates the amount of interest to be paid by the U.S. Treasury. It assumes that the average rate of 1.2% paid on outstanding Treasury debt in fiscal 2022 will increase to only 1.26% in 2023.

The budget assumes 91-day Treasury bills will average 0.9% and 10-year Treasury notes will average 2.5% in fiscal 2023. Those rates are obviously too low. If we assume the $5.5T in Treasury securities that mature in fiscal 2023 have an average rate of 1.2% and have to be renewed at a more realistic rate of 3.5%, then the interest expense will rise by $126.5B in fiscal 2023 and the budget deficit will be ~$1.281T.

Absent timing differences, if the U.S. Treasury decides to keep its September 28, 2022 checking account balance of $662B at the Federal Reserve throughout fiscal 2023, it will, therefore, have to sell $1.281T in additional securities over and above the $5.5T securities that mature to finance the deficit.

In addition to the $1.281T the U.S. Treasury will have to find buyers to replace the $720B (12 x $60B) in holdings the Federal Reserve is planning to not rollover. It will also likely have to find buyers to replace about a $331B reduction in U.S. Treasury holdings by China and Japan, assuming their holdings in fiscal 2023 are reduced by the same amount as fiscal 2022.

The U.S. Treasury will also not receive the $104.4B it received from the Fed in fiscal 2022 as a remittance. Each year the Fed remits to the Treasury its earnings, but in fiscal 2023 the Fed is expected to lose about $80B. The cause of the loss is that the average interest rate being earned on the Fed’s investment portfolio is less than the average rate it is paying on reserves.

The above figures indicate that the U.S. Treasury will have to sell $2.436T in Treasury securities during fiscal 2023. That figure is a total of the projected fiscal deficit of $1.154T, increased interest expense above budget of $126.5B, the Federal Reserve roll off of $720B, the estimated reduction in Japan and China holdings of $331B, and the loss of Fed’s remittance of $104.4B.

Who Will Buy U.S. Treasury Debt in Fiscal 2023

On at least three occasions the U.S. Treasury was in dire need of money to pay its bills. All instances occurred during times of war. The first instance was during the Civil War. To solve its cash problem the federal government required national banks to buy U.S. Treasury securities to support their issuance of bank notes.

The second time the U.S. Treasury was confronted by a need for cash was during World War I. In 1917 and 1918, the United States government issued Liberty Bonds via aggressive war bond drives appealing to patriotism.

War bond drives were dusted off and used once again during World War II. The WW II drives were led by Hollywood celebrities like Bing Crosby, who sang a famous song titled Buy Buy Bonds. It is worth listening to this song.

It is unlikely that the U.S. Treasury can solve its emerging cash crisis by once again creating a patriotic appeal. There is simply not enough time to organize a major fund raising campaign.

The Federal Reserve and Yield Curve Control

It is possible that the Federal Reserve will decide to utilize “yield curve control;” whereby, they set rates on U.S. Treasury securities just as they did in 1942 soon after the United States entered World War II. From July 1942 through June 1947 the Federal Reserve agreed to purchase Treasury bills at a rate of 0.375% per year while capping interest rates on 1-year issues at 0.875%, on 10-year issues at 2%, on 16-year issues at 2.25%, and on long bonds at 2.5%. The curve of interest rates was set slightly higher than what prevailed in November 1941, just prior to the attack on Pearl Harbor.

The 0.375% (37.5 basis points) peg on Treasury bill rates ended on July 3, 1947. Bill rates immediately began to rise and by the end of July they were 66 BPS and at the end of August they were 75BPS. At the end of 1947, Treasury bills were yielding 95 BPS.

Following the de-pegging of Treasury bills in 1947 the Federal Reserve started to gradually increase the cap rates on other Treasury securities. It began by incrementally increasing the cap rate of 1-year securities and then moved out to longer maturities.

Yield curve control officially ended with the signing of the Treasury Fed Accord on March 4, 1951. This is the date on which the Federal Reserve supposedly regained its independence from the U.S. Treasury.

The Bank of Japan “BOJ” was the first central bank to embrace quantitative easing (QE) and recently it has been experimenting with yield curve control as a way to bring inflation to a 2% target. In particular, the BOJ has sought to bring about a decline in real interest rates by controlling the short and long-term interest rates. Its efforts have had limited success during the last few years.

The Federal Reserve and QT

The Fed could satisfy the U.S. Treasury’s financing needs by abandoning its $60B per month roll off and once again increasing its holdings of U.S. Treasuries. A trigger for the Fed ending such QT could be fear of a failed U.S. Treasury auction and/or a sharp rise in interest rates further exacerbating the already severe depreciation in fixed income portfolios.

This is exactly what recently happened in England’s gilt market and caused the Bank of England to reverse its quantitative tightening and buy gilts. A surge in gilt rates had caused precipitous declines in gilt prices that threatened the solvency of leveraged pension funds and encouraged the Bank of England to end its QT.

Federal Reserve Reaffirms Roll Off Strategy

There is a remote possibility that the Federal Reserve would take a firm stance and assert that its dual mandate of maintaining high employment and price stability requires it to adhere to its roll off plan. That would be akin to revisiting the Treasury Fed Accord of 1951. By doing so the Federal Reserve would re-acknowledge its independence and gain immense credibility. It would of course be heavily attacked and its ability to withstand acute political pressure would be severely tested.

Conclusion

This article has shown that 21 years of profligacy by elected officials in the nation’s capital have finally brought U.S. Treasury financings to a breaking point. The U.S. Treasury must issue about $2.4T in additional debt in fiscal 2023 at a time when its largest two buyers, foreigners and the Federal Reserve, are in the process of shrinking their holdings of U.S. Treasuries.

There are three possible ways the U.S. Treasury financing issue can be resolved. One solution would entail individuals, insurance companies, savings institutions, pension funds, mutual funds, and/or other buyers adding significantly to their U.S. Treasury holdings. Such purchases would prevent the U.S. Treasury financing crisis from occurring and the stock, bond, currency, and commodity markets would be unaffected.

A second way to meet the Treasury’s financing need would be for the Federal Reserve to end its roll off of U.S. Treasuries and increase its holdings of U.S. Treasury securities by whatever is necessary to accommodate the U.S. Treasury. If the Federal Reserve ended its roll off it would send a clear signal it does not have the fortitude to fight inflation. The belief that inflation is inevitable, persistent, and unchecked would then have a tendency to gain traction.

The initial reaction of the stock market to the Federal Reserve adding U.S. Treasury securities would probably be positive, since the stock market has proven to be a prime beneficiary of easy money. Gold, silver, and other commodity prices would also probably increase, since they tend to do well during inflation. Long-bond prices, however, would probably fall along with the U.S. dollar because of inflationary fear being rekindled.

A third way to resolve the U.S. Treasury financing problem would be for the Federal Reserve to retain it present policy and force members of Congress to raise revenue or cut expenditures. Operationally, the U.S. Treasury would deplete all funds in its checking account at the Federal Reserve and depend on replenishing those funds by somehow obtaining money from other governmental agencies or having U.S. Congress raise revenues or decrease expenditures.

The fallout from the Federal Reserve refusing to alter its roll off program would be significant. The immediate reaction in the financial markets to a realization that the U.S. Treasury was out of funds would probably not be positive and volatility would undoubtedly increase. The longer term impact of the Federal Reserve not changing its monetary policy to accommodate the financing needs of the U.S. Treasury, however, is likely to have lasting positive effects on the stock and bond markets. Stock and bond investors would gain confidence that inflation and runaway government spending would no longer be tolerated. This may, in fact, be the last chance for the Federal Reserve to regain the independence it once claimed in the Treasury Fed Accord of 1951.

Albert Einstein reportedly said “in the midst of every crisis lies great opportunity.” That famous quote certainly applies to the U.S. Treasury financing crisis noted in this article.

The U.S. Treasury’s financing crisis is the first real opportunity in 71 years for the Federal Reserve to bring about lasting change in fiscal policy by forcing elected officials to reduce spending and/or raise taxes to balance the budget. It will be interesting to watch how the U.S. Treasury financing issue is resolved.