The Fed no longer controls interest rates

Excess debt, demographic changes and buyer resistance now have the reins

Economists like to talk about the “natural rate of interest” - the rate that balances savings and investment and allows inflation free economic expansion. It was all the rage in the 1950’s and 1960’s and today it is an irrelevant concept. Too much sovereign debt, too much interference in markets by both government and the Fed, and demographic changes have handed the reins back to bond investors. The conclusion investors should draw is that the era of low interest rates is long gone. This chart from a recent Bloomberg article making the point shows the trend.

The Bloomberg article notes that during the period of QE the government got “a pass” from bond investors (mainly because the primary investors was the Fed) and were able to increase government debt by enormous amounts without driving up the cost to service that debt by a similar amount. With money essentially free, Washington lawmakers could not resist the temptation to buy votes with borrowed money and the leftist economists who promoted Modern Monetary Theory (MMT) abetted them with a nonsensical theory that there was no limit to the amount to debt the government could “print” without fueling inflation.

The MMT theorists saw no limits and touted the ability of the economy to grow without inflation while the “natural interest rate” turned negative. Reality sets in slowly, not overnight, and it is setting in today. No one want to buy U.S. treasuries since there is now real risk of default as the cost of serving the $34 trillion debt has reached over $1 trillion and the debt is still growing by a trillion or two every year. The average rate on U.S. outstanding debt is increasing rapidly and new debt needs coupons close to 5% to attract buyers. This chart from Statista shows the trend as of September 2023 as the average rate approached 3%. Three percent of $34 trillion is over $1 trillion and as debt with coupons of 1% to 2% gets refinanced that average rate will surely rise to the 5% range if not higher. Interest on U.S. government debt will exceed $2 trillion annually before long, about double what the country spends on national defense.

Demographic changes are a headwind for the Treasury. Fewer young people entering the workforce with a higher percentage of the population retired puts pressure on the cost of “entitlements” like social security and Medicare and the working population’s ability to carry that burden is weakening as the relative number of active workers to retired persons shifts towards more retired and fewer at work.

This week’s bond auctions with over $100 billion of new supply hitting the market may demonstrate who is in charge of interest rates. If not this one, the next one. A failed bond auction and the leftist game comes to an ugly end.