In A U.S. Sovereign Debt Crisis, Gold May Be The Best Place To Hide

I was in Stockholm, Sweden, on Tuesday January 10 and read US Federal Reserve Chairman Jerome Powell’s presentation at a Riksbank (Sweden’s Central Bank, the world’s oldest as it was founded in 1668) symposium on central bank independence. This was Chairman Powell’s speech:

Speech by Chair Powell on central bank independence

Of all things in the world, there is little with which to disagree about Chairman Powell’s remarks, for as far as they go. He said that a central bank, such as the US Federal Reserve, needs to be independent in order to take decisions that may be politically unpopular in the short term.

There is an important limit to Chairman Powell’s remarks, however: The difficulty of the nature of the task. Yes, the Fed should be independent so that it can take politically unpopular decisions. The problem is that this says nothing about the options available given the nature of the circumstance: Yes, the Fed can take unpopular decisions, but will it, under political and public pressure?

Being brave doesn’t say much about the outcome when faced with an impossible situation. If you are facing a flock of hungry lions or you’re on an airplane where the wing just fell off, it may not matter if you are “independent” or “brave” — because you are about to meet your maker no matter what you may be willing to do in order to attempt to rescue the situation.

As usual, they say it’s difficult to predict the macroeconomic outcome

Macroeconomic predictions are normally difficult and uncertain. There are many variables, and the outcomes could swing in multiple ways. From 1987 to 2020, there was always some “escape hatch” that the Fed could pull, in order to avoid a total economic meltdown. In plain English, that meant cutting interest rates and/or engaging in some form of quantitative easing, aka “money-printing.”. And guess what? 1987 is about as far back as almost all of today’s active Wall Street careers go. Almost everyone working on Wall Street today knows nothing about investing in anything that works beyond falling interest rates and rapid expansion of the quantity of money.

However, the main issue that is now confronting the U.S. — and some other countries — is in my opinion unusually easy to predict, as we enter 2023. The forces at play are so harsh and radical that I estimate that not even a miracle could prevent the greatest financial crisis in a century from unfolding already within the next year or two.

This time it’s easier: The inescapable math appears devastating

All you need to know in order see where things are going on the macroeconomic front is to combine a four hard cold facts about our macroeconomic circumstance:

• US Federal issued debt to GDP is 125% and rising fast.

• US Federal real cash budget deficit is at a record level and rising fast.

• Interest rates on the US debt are growing from around 1% a year ago to a projected 5% in the coming year.

• The US Federal Reserve goes from $120 billion per month in Quantitative Easing (QE) to $95 billion per month in Quantitative Tightening (QT). That is a $215 billion per month swing, draining market liquidity.

Any one of these four facts could potentially be survivable by a nation, in isolation from the other negative circumstances. Combine that one negative factor among the four above with favorable conditions among the three other factors, and you might “only” have a recession, even if it’s a deep one.

The problem with 2023 is that all four of these storms are now hitting the target simultaneously. It is a perfect storm: A once-in-300 years Category 7 twister. Nobody alive today has seen anything like it happening in the US markets in their lifetime.

Let’s take the four components of the “Category 7” perfect financial storm in turn, and comment on how any one of them could be survivable (but isn’t!):

• You could deal with the record debt if the economy was booming (GDP growth), the deficit was zero or negative, and interest rates were falling. But the opposite is happening.

• You could deal with a rapidly growing budget deficit (for a while) if it came on the backs of having no debt (or being a creditor) so that you could “invest” for a while, plus pay it off with superior economic growth and a high/rising level of personal savings. But the opposite is happening.

• You could deal with sharply increasing interest rates if the debt level was low and falling, and if the budget deficit was also low and falling. But the opposite is happening.

• You could deal with going from huge QE to huge QT if all the three factors above were going in the opposite direction. But the opposite is happening.

In short, every single factor that could be tilting over the US fiscal ship into the wrong direction, is happening. It’s a “four out of four” in terms of deadly macroeconomic blows: Heart attack, stroke, stage four cancer and poisonous snake bite — all at once.

In an airplane analogy, the wing fell off, one engine is on fire, the other engine is dead, the jet fuel tank ruptured, and the pilots both had simultaneous heart attacks. This plane is crashing with zero probability of even the slightest hope of survival for anyone on board. It’s over.

The macroeconomic equation hits immovable object at full speed

In case the impossibility of this situation isn’t clear to you, let me spell it out: The US has financed the Federal deficit to a large extent with the US Federal Reserve buying US Treasuries.

Now, the US Federal Reserve says it isn’t going to be buying those treasuries anymore. Adding insult to injury, it is going to unload competing treasuries from its nearly $9 trillion balance sheet. Whatever interest rate the US Federal government was going to pay when it wasn’t competing with The Federal Reserve, it may have to be dramatically higher given that its big buyer isn’t buying anymore. Worse yet, the Fed is outright selling. That’s catastrophe squared for the US Treasury, as interest rates will likely have to increase sharply in order to attract new buyers. This is not some sort of controversial theory, but rather simple bond math: Much lower demand in the face of much higher supply, means higher interest rates. This is the textbook case for a sharp increase in interest rates.

But wait, there is more! Maybe this would work if the US Federal deficit was low and falling. If so, having to sell more bonds to non-Fed sources wouldn’t matter much, if at all. The problem here is that the US Federal budget deficit is now the highest ever, and rising fast. The US Treasury has indicated annualized borrowing needs of $2.6 trillion as the current deficit rate. That’s almost 10% of estimated GDP for the next year, or nearly double where it was only last year.

Actually, there is even more! All of those things might be mitigated by sharply falling interest rates. The problem here is that interest rates are going up, not down. The US government borrowed increasingly short-term in the last decade, and is now going to see a multiplication of the interest rates it is paying, over the next few short years, as the old debts roll over from 1% to 5%.

In short: Everything that could possibly go wrong for the US fiscal position, is going in the wrong direction — and hard, and rapidly. If the Fed continues to do what it says it will do — staying “unpolitical” as described in Chairman Powell’s speech here in Stockholm earlier this week — then the US fiscal position could turn into the largest sovereign financial collapse in over a century. As I will show below, it really doesn’t matter what the Fed does at this point, as the end result looks to be the same in terms of long-term interest rates and an associated economic collapse.

We can compare the disastrous macroeconomic situation in the US with here in Sweden (where Chairman Powell presented this week) and Turkey (which is often used as an example — not by me! — of what should not be copied):

Click to enlarge

Data Source: Statista

Three points emerge from the table above:

• Issued debt by the central government: The US has by far the most amount of debt in relation to its GDP, approximately 3x Turkey and 4x Sweden.

• Central government deficit in relation to its GDP: The US is as bad as Turkey, and dramatically worse than Sweden.

• Economic growth: US economic growth is half as fast as Sweden, and one-third that of Turkey’s relatively fast-growing economy.

Let’s see: The US has the most debt, the highest deficit, and the slowest economic growth. In this precarious situation, US interest rates are skyrocketing and the US Fed is not only going to stop buying US treasuries, but also start to unload its balance sheet of the Treasuries that it already purchased over the last decade. All of that in a rising interest environment. What could possibly go wrong? Answer: Everything looks to be guaranteed to go wrong.

The Fed pivot: I dare you

The reason that the market has not tanked more in recent months, with these prospects, is that the broad market consensus has a solution to this sovereign debt crisis/problem: The Fed is going to “pivot” — cut interest rates, and more importantly stop selling Treasuries in favor of once again buying them in great quantities, such as well over $100 billion per month, instead of selling a similar amount. Remember, at $2.6 trillion per year worth of a deficit, the Fed is likely going to have to buy approximately $200 billion of treasuries per month, in order to finance the US Federal budget deficit.

Why may such a Fed pivot not work this time? I submit that a critical factor has changed this time, compared to anything that US market participants have known ever since the 1987 October Black Monday crash….