Ambrose Evans-Pritchard
A dangerous view is creeping into the markets that the US has already gone so far down the path of a debt compound trap that it dare not raise interest rates to control inflation.
The US Treasury has become acutely dependent on short-term funding from hedge funds, many tapping the $US8.3 trillion ($11.6 trillion) money market and some operating with up to 100 times leverage. The share of purchases coming from stable lenders, such as foreign central banks and sovereign wealth funds, has been drying up.
Steven Blitz, the chief US economist at TS Lombard, says the Federal Reserve cannot tighten hard without risking a chain reaction. Financing costs would “explode”.
“Raising rates today immediately impacts the cost of nearly 25 per cent of the federal debt, where issuance is growing fastest,” he said.
The US Treasury has to roll over $US6 trillion of debt every three months in an increasingly sceptical market, as well as issuing $US2 trillion of new debt annually to cover the worst structural deficit in US peacetime history.
Annual gross financing needs – the key warning metric watched by rating agencies and bond funds – was 26 per cent of GDP in 2010. The International Monetary Fund says the figure will reach 45 per cent this year and is on track for 60 per cent by the early 2030s on current policies. No great power has long endured at that sort of level.
Scott Bessent, the poacher-turned-gamekeeper now in charge of the US Treasury, has been concentrating ever more borrowing on short-term bills. It is a way to keep a lid on the spiralling interest cost of the US national debt, which has quadrupled to $US1 trillion in a decade, now exceeds the US defence budget and is fast heading towards uncharted waters above 4 per cent of GDP.
But trying to defer America’s fiscal reckoning by monkeying with debt instruments is the trick used by broken hegemons through the ages. It is a Faustian pact.
We know how worried Bessent is about soaring bond yields – approaching a two-decade high – by the way he intervened alongside Japan earlier this month to halt speculation against the yen. He activated an obscure mechanism known as the FIMA Repo Facility to let Japan pawn a chunk of its $US1.1 trillion of US Treasuries in exchange for dollar loans rather than selling these bonds on the open market.
He joined the action by mobilising the Treasury’s holding of euros, without first telling the European Central Bank – a shocking breakdown of central bank etiquette. All this screams desperation.
Hedge funds have become the marginal buyers of US debt, doubling their share to 9 per cent of total US Treasury purchases over the past four years. They have been borrowing with extreme leverage on the repo market – a core part of financial plumbing – in order to extract arbitrage gains.
Both the IMF and the Bank for International Settlements have warned that this structure is an accident waiting to happen. It amplified a spiral of forced selling and a near meltdown of the US Treasury market in the COVID panic of March 2020. The critical point is that the whole US financial and fiscal system has never been so sensitive to short-term interest rates.
Kevin Warsh, the untested new Fed chairman, faces an invidious choice. The indecent manner of his appointment degraded his credibility before he even started. Markets know that President Donald Trump persecuted his predecessor for refusing to cut rates and refusing to become the infamous Arthur Burns of our age. They also know that Warsh’s billionaire father-in-law is a close Trump confederate and a key author of the Greenland grab.
Warsh struggled to articulate a coherent intellectual argument after the most recent policy meeting for why he was not raising rates. He could not explain how he intends to bring stubborn US inflation back towards the 2 per cent target when it is clearly going the other way.
“Sternly staring at inflation until it melts before our withering gaze is not an option,” fellow Fed board member Christopher Waller said.
Warsh faced the unusual rebuke of three voting dissenters and some have been outspoken to the point of contempt. The market verdict has been lapidary.
Warsh argues that AI is deflationary and therefore overrides the Phillips Curve, making it possible to combine blistering growth with low inflation. I am friendly to this line of thinking, but it is not entirely convincing coming from Warsh, who used to be a chest-beating “inflation nutter”. Many suspect that he has latched on to this idea as a pretext for doing Trump’s bidding.
Reports that he talks to Trump “all the time” confirm the fears. Previous Fed chairman Jerome Powell’s working code was always that the proper level of intercourse between the US president and the Fed chairman is “zero”.
The Dornbusch adage in the markets is that fiscal and financial crises take longer to happen than you think possible but then happen faster than you ever imagined.
We know that US federal debt is compounding at a rate of 3.5 per cent of GDP each year. The mechanical rise in entitlements – ie, middle-class welfare – has been part of the landscape for a long time. Trump 1.0 tax cuts, COVID and Joe Biden’s Rooseveltian New Deal together pushed the envelope a lot further. Trump 2.0’s One Big, Beautiful Bill tests the limits.
The IMF forecasts a US general government deficit of 7.4 per cent of GDP or higher every single year from 2026 to 2031. Now Trump wants to raise the Pentagon budget by 60 per cent and fritter away $275 billion on his “golden fleet” of Trump-class battleships – an idée fixe ever since he watched the 1950s telly series Victory at Sea.
It takes a serious trigger to detonate a crisis of financial confidence in a great power with deep economic strengths and a world reserve currency. Military overstretch is usually to blame, the cause of imperial Spain’s default in 1575 and Britain’s convertibility crisis in 1947.
The ingredients for some sort of American financial crisis are falling into place, disguised for now – but also compounded – by the AI bubble. The global market no longer has full faith in the management of the US Treasury and the Fed.
The Dornbusch adage in the markets is that fiscal and financial crises take longer to happen than you think possible but then happen faster than you ever imagined.
The US has stopped upholding free trade and open navigation, switching sides to become the chief instigator of piracy and world disorder. It has squandered much of its arsenal on an ill-planned war that it cannot end without accepting humiliation and that has shown the US to be a weaker military power than we all thought. It has further wrecked US alliances and largely played into the hands of Xi Jinping’s revanchist China.
The disaster is nearly complete. Now we await the US midterm elections. Should the democratic transfer of power in Congress be obstructed by meddling with the results in swing states, we may have our trigger.
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