The Days Ahead:

  • Retail sales and housing

This Week:

  • The widening budget deficit
  • It’s up because of higher interest rates, Fed earnings and lower taxes..
  • Not because of increased spending
  • A flood of new Treasuries
  • But there are plenty of buyers and new auctions are ok
  • Ships are queueing up to get through Panama
  • And commercial traffic on the Rhine has a problem.

The Budget Deficit Is Widening

It’s about this time of the cycle that investors start to worry about budget deficits. We heard a lot about out-of-control spending and unfunded tax cuts at the time of the debt ceiling discussions in May and June. Those two views of “we spend too much” and “we cut taxes too much” are difficult to reconcile and any middle ground hard to find. We expect these two points to resurface in the budget negotiations, which start when the current funding runs out on September 30th.

It’s true that the latest projection from the Congressional Budget Office (CBO) shows the budget deficit at 5.8% for 2023, which is up from 5.2% in 2022 but much better than the 14% and 12% we saw for 2020 and 2021. Normally, we’d expect deficits to grow during and immediately after recessions and then improve up until the next recession. There’s no mystery to it. People are laid off, tax revenues decline and support programs like unemployment benefits rise. The latest numbers for daily unemployment benefits is around $137 million, which works out to about $74 a day or $370 a week for the 1.8 million unemployed who receive them. There are another 4 million unemployed who do not bother to claim or are not eligible for benefits.

The $137 million is about in line with daily benefits paid from 2002 to 2007 and 2014 to 2020. They rocketed up to $4,718 million in 2020 but fell rapidly in the last year or so. The numbers are not seasonally adjusted so we see big jumps in the new year and mid-summer when seasonal workers leave the workforce. This is what it looks like.

Graph showing the daily unemployment benefits paid in the U.S.
Source: FactSet, 8/7/2023

So, unemployment benefits are low and we have a record 161 million people at work. We also have record levels of personal income, especially the proportion made up of wages and salaries.

Graph showing U.S. personal income and wages.
Source: FactSet, 8/7/2023

Everything should be running with a “procyclical” bias, with taxes up, emergency spending down and the economy humming at full employment. This should be halcyon days for budget deficits. But this is what the income and outlays look like on a 12-month moving average:

Graph sowing the U.S. Treasury revenues and outlays.
Source: FactSet, 8/7/2023

Outlays (green line) are up around 14% since last year and receipts are down around 10%. The gap between the two is, roughly, the running budget deficit. We would expect that a widening deficit, even though it’s coming in the wrong part of the cycle, would help the economy. But the widening gap is almost entirely due to three factors, none of which help.

One is higher interest rates. The public portion of government debt is roughly composed of 20% in bills and 72% in notes and bonds, which range from 2 years to 30 years. The average rate paid on bills is  5.2% and for the notes and bonds is 2.24%. The second number seems low compared to the current rate of around 4.0% for a 10-year U.S. Treasury and 4.2% for a 30-year U.S. Treasury but many of those longer notes and bonds were issued in the low interest period of 2010 to 2022.

A year ago, the rate for both bills and notes was 1.5%.. Two years ago, they were 0.05% and 1.5%.

The total amount of debt has also risen from around $23,290 billion a year ago to $25,118 billion now and the amount in bills has risen from 15% to 20% of the total. So, there’s more total debt and more expensive short-term debt. You may often hear that the total public debt is 123% of GDP at $32,608 billion. That’s true but $7,471 billion of that is held by intra-government agencies, mostly Social Security and various government pension funds. It’s a bit like one subsidiary of a company owing money to another, and, yes, it can be described as “total debt.” But it’s the net, or publicly held, debt that counts, and that’s at $25,118 billion.

The interest payments on the debt now look like this:

Graph showing the U.S. Treasury gross and net interest payments.
Source: FactSet, 8/7/2023

It’s a 12-month moving average with gross interest at $75 billion a month and net interest at $52 billion, up 80% from a year ago.

That’s a lot of numbers but the quick summary is that debt is up 8%, the rate paid on bills is up from 1.5% to 5.2% and the total bill to pay the debt is up 80% to $52 billion a month. Meanwhile nominal GDP is up 4.3% and personal income up 4.5%.

Two, is that the Fed isn’t earning as much for the Treasury as it used to. The net interest line above is basically the interest paid by the Treasury to investors less what the Fed earns on its Treasury and MBS portfolio. If the Fed earns more interest than it pays, it hands over the difference to the Treasury at the end of the year.

But two things are changing.

First, as we know, the Fed is gradually drawing down its System Open Market Accounts (SOMA) holdings. They’ve already fallen from $8,344 billion a year ago to $7,459 billion now. So, the Fed is paying less over to the Treasury because it holds fewer bonds. The trend will continue for years.

Second is the Fed’s excess earnings. This gets a bit complicated but if the Fed makes money from its operations, it pays the Treasury at the end of every month and then trues-up at the end of the year. In 2021, excess earnings were about $3 billion a week but in late 2022 they fell to zero. They’re in the weekly report from the Fed and rather quaintly called “earnings remittances due to the U.S. Treasury” 

They’re currently running at negative $86 billion. What’s happening is that the Fed earns interest on its investment portfolio but it also pays interest on things like reserve balances, where it pays 5.4%, and the reverse repo window, where it pays 5.3%. Those two balances alone are $5,000 billion so the Fed is paying around $264 billion while earning around $74 billion from its SOMA holdings. The beneficiaries of those extra payments are banks and money market funds but, of course, it’s all the function of an inverted yield curve. In this case, the Fed pays out more for overnight rates than it earns on its long-term investments.

The bottom line is that in 2022, the Fed was paying around $3 billion a week in to the Treasury; but then this happened:

Graph showing the Federal Reserve earnings for the treasury.
Source: FactSet, 8/8/2023

The chart is a bit misleading because once the weekly number goes negative, the Fed switches to a cumulative number, so the chart falls off a cliff. The Fed then posts a “negative deferred asset” to the Treasury. It’s a bit like an IOU that it never has to pay. It doesn’t affect the Fed’s operations but it’s less money for the Treasury. In 2021 and 2022, the Fed remitted $105 billion and $77 billion to the Treasury. Now it’s posting an $86 billion loss. It’s slightly more than shown in the graph because of some operating costs, foreign exchange losses and “other” liabilities.

The third reason for the widening gap is lower taxes. Total personal taxes so far in 2023 are $2,385 billion of which $860 billion is in “declarations and settlements”, a catch-all bucket which includes non-withheld income, legal settlements and capital gains. The BEA does not report capital gains as a stand-alone item but we can sort of estimate capital gains at around $602 billion.

In 2022, taxes were $2,598 billion of which capital gains were around $900 billion. Last year was a bumper year for capital gains tax payments given the strong equity markets in 2021. But in 2022, stocks and bonds were down over 20% and capital gains, payable in 2023, are down sharply. Federal taxes in 2023 are down $213 billion. This, at a time when we have close to full employment and 3 million more people working.

We’re also seeing lower taxes because California extended its tax filing deadline to October 16, 2023. That won’t affect normal withheld income taxes as they’re pay-as-you go taxes. But it will affect other taxes like estimates, non-withheld income, capital gains and settlements. So how much will come to the U.S. Treasury from California’s late filing? Difficult to say but Californians paid $90 billion in taxes in the second quarter of 2022 and only $57 billion in the same period of 2023. The late filing should help the U.S. Treasury out in mid-October.

So put all this together and we get this:

Graph showing government outlays including interest on public debt.
Source: FactSet, 8/8/2023

The chart shows all Federal outlays less interest payment in the green line and the interest payments in the blue line. The green line, which counts all government departments, is running at around $489 billion a month compared to $500 billion just over a year ago. That means that there is no fiscal stimulus at work. The government is not paying any more for goods and services than it did a year ago. All the increase in the budget is due to higher rates, lower earnings from the Fed and lower tax receipts.

We don’t have to worry about it now because unemployment is low. But to us it means two things. One, if there’s no fiscal stimulus at work, inflation is likely to moderate. And two, if there is a recession and budget deficits need to climb, the interest costs could be a lot higher than we’ve been used to for the last 15 years.

Wow, a Lot of New Treasuries are Coming.

We mentioned last week about the new Treasury issuance calendar for the July to September period.  

During the debt ceiling negotiations, the U.S. Treasury was unable to issue new debt and resorted to “extraordinary measures.” This meant things like stopping the funding of the Civil Service Retirement and Disability Fund, which covers 2.8 million employees and another 2.7 million retirees. That freed up around $140 billion.

The Treasury also went to the “G Fund”, which is the Government Securities fund in the Thrift Savings Plan, a sort of 401(k) for government employees, and stopped reinvestment of maturing securities. The G-Fund uses non-marketable securities that are unavailable to the public so it had no effect on rates. That move freed up another $250 billion. In both cases, retirees and employees suffered no financial loss. It’s just that both plans went unfunded for a few months.

Bar chart showing treasuring coupon issuance for Q2 and Q3 2023
Source: U.S. Treasury, Cecity Partners

Come the end of the debt ceiling, cometh the reckoning.

Now the Treasury must issue the bills, notes and bonds it couldn’t in the months of debt ceiling discussions and pay back the two pension funds. The market was expecting a big jump in Treasury issuance and last week so it was.

In the July to September period, Treasury will borrow $1,007 billion up $274 billion from the last estimate and up from $657 billion in the April to June quarter. It’ll use the money for general spending but it also need to rebuild the Treasury General Account by another $200 billion after it was run down to only $23 billion in June. There’s also around $150 billion needed to replace SOMA holdings redeemed by the Fed. This is the biggest quarterly refunding in the last 10 years, excluding the onetime $2,753 billion raised in the midst of Covid-19 in 2020. It’s also twice the level of the amounts raised last year.

As we’ve mentioned before the Fed will continue to issue short-term bills but it also needs to raise more “coupon” bonds, which are bonds ranging in maturity from 2 -years to 30 years. Here’s what’s coming in the next few months:

The question is, “Who’s going to buy all these Treasuries?”. Fortunately, that’s not a problem. Banks have been pulling away from the market but there are many domestic funds and investors who are only too glad to see bonds yielding nearly double what they were between 2008 and 2022. Overseas demand should also remain strong. As we discussed last week, U.S. Treasuries still yield more than other sovereign bonds, even if they choose to hedge the currency exposure.

The Bank for International Settlements (BIS) is the central banker’s central bank and doesn’t often make predictions. They wrote:

We estimate that a 1 percentage point increase in long-term yields leads to an 11% increase in the demand by non-central bank players for US Treasury securities.”

If that’s the case, with the 10-year U.S. Treasury some 0.75% above its average 2022 price, and with $18,000 billion of U.S. debt not held by the Fed, demand should rise by $2,000 billion. We doubt it will be quite that much, but we do believe there’s plenty of demand out there.

Finally, as we discuss a lot around here, what moves the bond market is the outlook for growth, inflation and interest rates, not supply. You would think that over supply would flood the market or crowd out investment, but there’s little proof that it does. We think the markets should absorb the new supply without much drama and this week’s auctions showed relatively good demand.

A Man a Plan A Canal

An astute colleague drew our attention to this very fun marine traffic map.

Map of marine traffic.
Source:, 8/10/2023

That’s over 200 ships waiting to enter the Panama Canal from the Pacific and Caribbean sides. The canal can usually handle 40 ships a day. There are 12 locks and each lock is 320 meters long. That means it can take one Panamax ship, which is exactly designed to fit in the lock, or, of course, more smaller boats. But the average cargo ship is now around 320 meters and anything smaller is either a pleasure boat, a tug or a Naval vessel. It usually works smoothly, as this fun 24-hour time-lapse shows.

But there’s a problem now. The lake in the middle of the map above is used to fill and drain the locks and water levels are at all time lows. It needs 75 feet of depth to work and it’s at 80 feet now. Canal authorities have limited traffic or required ships to operate at 60% capacity. Traffic is down to 28 ships a day and the wait time around 10 to 18 days depending on the size of the ship and in which direction it’s headed. Daily operating costs for a Panamax ship are around $21,000.  A wait of 10 days can seriously eat into the profitability of a cargo ship. Some ships are cancelling or taking the long way round via Cape Horn, which adds significant costs. Over half of the Panama traffic is intra-U.S. trade, taking things from the east coast to the west coast and back. Some cargo can be diverted to rail, pipeline and road, but not easily and not quickly. Even Royal Caribbean has cancelled some cruises for 2024 as they don’t expect the delays to improve.

Meanwhile in Europe, there’s a similar problem on the Rhine. Some 35% of Germany’s and the Netherland’s transport of goods, oil and natural gas, goes by inland waterways, and over 170,000 commercial ships and boats use the Rhine every year.

But the Rhein’s’ water levels are low and the lowest levels are around Kaub, where current water levels are 179 cm, or 70 inches. This 60 inches below the long-term average. A regular barge, one that can carry the equivalent load of 150 trucks, needs 60 inches of water to operate. In a few weeks, the water levels will fall and then those barges will have to operate at 50% capacity (to make them draw less). New ships, like this beauty, need only 11 inches to operate and they’re building them as fast as they can.

Photo of a barge ship.
Source: BASF SE

But it will take time.

Meanwhile the rule of thumb is that if the Kaub water levels fall below 31 inches for 30 days, as they did in 2018 and 2022, German industrial production falls, as explained by the Kiel Institute:

A month with 30 days of low water levels on the Rhine dampens overall inland water transportation by about 25 percent and industrial production by about 1 percent.”

In both Panama and central Germany, drought is causing current traffic, logistic and delivery problems. There are solutions, and giant barges that draw less than a foot of water, are mighty impressive and point to more capital expenditure. But in the short term we’ll see disruptions and delays.

The Bottom Line

The major news this week was the lower inflation number. The headline number came in at 3.2%, up from 3.0% but this is partly because of the base effect from a year ago. The monthly number for both headline and core was 0.2% for the second month running. The number that’s still big is the shelter component which is up 8.0% on the year but slowing, at 0.4% on the month. Shelter is over 40% of the core inflation measure so it really needs to fall if we’re going to see headline inflation closer to the Fed’s target. The good thing is, that is exactly what will happen. As we’ve mentioned before, the “shelter” measure lags rent growth by up to a year and we know that rent growth has slowed all year. That will start to show up in the Bureau of Labor Statistics inflation report soon.

The markets liked the report with stocks up on the news, although they gave up some of the gains later in the day. It was the same reaction with Treasuries, although, again, some of the gains drifted after the announcement of the first new 30-year Treasury auction in three months.

The rest of the week was a mix. We saw mortgage rates above 7% again. They’re at their highest since 2001. But we’ve known about housing market weakness for over a year, so no real surprise. Consumer credit went up more than expected, probably mostly into new car loans (the data lags). Household finances are in good shape. We’re not concerned about the over-leveraged consumer. We’d be tempted to lay the blame for a rather listless week on summer trading and a slow news week. The Jackson Hole symposium starts on August 24th and we’re unlikely to hear anything new from the Fed until then.

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Art: Petra Cortright (b. 1986)

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