It is not often one chart changes my view on something, but when looking at a chart of the Treasury deposits at the Federal Reserve, it became clear to me how the U.S. Treasury inadvertently extended the business cycle and helped create President Trump’s booming economy. It is also entirely probable anyone who won the 2016 Presidential election would have experienced a similar economic rebound due to the U.S. Treasury’s debt cycle. Once you understand how the U.S. Treasury’s debt cycle works, you will see how the economy benefited under President Trump and how to use the debt cycle to predict the direction of the economy and interest rates.
The U.S. Treasury holds cash in accounts at the Federal Reserve member banks to meet government spending needs when Congress is late in passing a spending bill. For reasons unknown, starting in 2015, the U.S. Treasury increased its savings from around $80 billion to $400 billion in 2016. Since 2016, the U.S. Treasury has sought to bring its savings up to approximately $400 billion to fund the government for up to three months should Congress need more time to pass a spending bill.
The purpose of the U.S. Treasury’s savings accounts is not to pump the economy but to prevent the government from shutting down due to a lack of funds since Congress tends to postpone spending bills until the final hour. When the U.S. Treasury deploys its savings, it has a profound effect on the economy. Oddly enough, and unintentionally, by dumping a large supply of dollars into the economy in 2016 through early 2017, the U.S. Treasury extended the business cycle by creating a mini-economic boom.
The recent economic boom was not repeated in late 2018 through early 2019 as the U.S. Treasury spent down its cash reserves before another spending bill was passed. For the magic of 2016 to be repeated, the cash from the U.S. Treasury’s savings accounts needs to multiply through the banking system, which it did not due to a slowing global economy and a lack of lending demand from tighter financial conditions.
The unintended effects of the U.S. Treasury’s borrowing are like the cycles of a four-stroke engine. The intake stroke begins when Congress passes a spending bill and the U.S. Treasury begins borrowing from domestic and foreign investors, along with foreign central banks, all who have U.S. Dollars to lend. It is important to understand that the borrowed currency is removed from the global supply of dollars, which leaves the world with fewer dollars to conduct global trade.
The compression stroke begins over the three-to-six-month period after the U.S. Treasury’s savings accounts at the Federal Reserve member banks are filled. For reasons unknown, the currency held in the U.S. Treasury’s savings accounts is removed from the broad currency supply, even though every penny is accounted for. At this stage of the cycle, the currency is available but is not needed until the government begins to run short of currency.
The power stroke, or combustion stroke, is when the saved currency flows out of the U.S. Treasury’s savings accounts and into the broad economy. Due to the currency being removed from the broad currency supply when it is borrowed, it is a direct injection of currency into the monetary system when it is spent. This has the unintended consequence of a very strong economic stimulus to the broad economy.
The final stroke, or the exhaust stroke, is where the broad economy feels the effects of the currency being spent in the economy. The output of the cycle is entirely dependent on borrowing demand. When the new currency hits the broad economy and is used to borrow more currency, it is multiplied through the banking system which leads to further economic growth. When the new currency is used to pay against existing debts, it is not multiplied, and it has little effect on the broad economy.
From a monetary perspective, the U.S. Treasury debt cycle has an impact on the economy and interest rates. During the intake stroke, the currency is removed from the economy and interest rates often rise from the effects of the prior debt cycle. In the compression stroke, interest rates tend to fall as the economy tends to slow from currency being removed from the economy.
When the power stroke kicks in, economic growth and the direction of interest rates solely depends on if the currency stimulus was multiplied by the banking system. When lending demand increases along with a currency injection, the economy expands, and interest rates rise. When a currency injection is not met with an increase in lending demand, the economy stagnates, and interest rates fall.
In the last phase of the cycle or the exhaust stroke, interest rates tend to fall as the stimulus wears off. If interest rates fall far enough and there is pent up consumer demand, the economy expands, and interest rates rise as the next intake cycle begins.
In the six months following October 2016, the U.S. Treasury was in the intake stroke as it borrowed $478 billion. As the cycle shifted into the compression stroke, Treasury yields fell to their all-time lows by mid-2016, which spurred lending demand ahead of the 2016 Presidential elections. Then in the first quarter of 2017, the U.S. Treasury drew down its cash reserves by $307 billion.
The stimulus created by the U.S. Treasury in the first quarter of 2017, led to further economic growth and higher interest rates. When the U.S. Treasury began to slowly refill its savings accounts by $243 billion from mid-2017 through the end of 2018, economic growth was strong enough to absorb most of the currency drain from the economy. By early 2018, Treasury yields began to flatline as the borrowing cycle entered the compression phase.
Due to the fiscal stimulus from the Tax Cut and Jobs Act of 2017, the economy expanded, and interest rates rose during the compression phase of the debt cycle whereas normally interest rates start falling. As the U.S. Treasury began to spend down its cash in mid-2019 as the cycle shifted into the power stroke, interest rates were still falling from the compression stroke.
When interest rates fell to their all-time lows, the stimulus from the power stoke had passed as the debt cycle entered the exhaust stroke. The additional stimulus from the currency injection did not work as it came too early in the debt cycle, again due to the tax cuts extending the cycle, and the lack of consumer demand for new loans.
Beginning with the fourth quarter of 2019, the U.S. Treasury is back in the intake cycle as it plans to borrow $318 billion and another $383 billion in the first quarter of 2020. Based on the debt cycle of the U.S. Treasury, the broad economy should soon start feeling the effects of the currency drain. Without a large increase in commercial and consumer lending, the effects of the currency drain should be compounded, especially since lending growth slowed considerably in the fourth quarter.
From an economic standpoint, with the U.S. Treasury’s cash balance expected to hit $410 billion by year-end with another $383 billion being borrowed in the first quarter of next year, the broad economy should continue to slow. Interest rates should also resume their downward trend as the monetary system needs lower interest rates to spur lending demand.
Based on the U.S. Treasury’s debt cycle, the economy should continue to slow through the end of the first quarter of 2020. Starting around the second quarter of 2020, if interest rates fall enough to spur a substantial increase in lending demand, the next power stroke could lead to an increase in economic growth. When low-interest rates are met with a currency injection, it tends to be economically stimulative.
It is not often one chart has a substantial impact on my view on the economic cycles and interest rates. With increasing deficits, the U.S. Treasury’s debt cycle is going to have a major impact on economic growth and Treasury yields. For the next several months, investors would be wise to look towards the bond market for price appreciation, as the compression stroke of the debt cycle tends to lead to lower long-term interest rates.
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