We are not sure of how the next financial crisis will exactly unfold but reasonably confident it will have its roots in the following analysis. Maybe it has already begun.
The U.S. Treasury market is the center of the financial universe and the 10-year yield is the most important price in the world, of which, all other assets are priced. We suspect the next major financial crisis may not be in the Treasury market but will most likely emanate from it.
U.S. Public Sector Debt Increase Financed By Central Banks
The U.S. has had a free ride for this entire century, financing its rapid runup in public sector debt, from 58 percent of GDP at year-end 2002, to the current level of 105 percent, mostly by foreign central banks and the Fed.
Marketable debt, in particular, notes and bonds, which drive market interest rates have increased by over $9 trillion during the same period, rising from 20 percent to 55 percent of GDP.
Central bank purchases, both the Fed and foreign central banks, have, on average, bought 63 percent of the annual increase in U.S. Treasury notes and bonds from 2003 to 2018. Note their purchases can be made in the secondary market, or, in the case of foreign central banks, in the monthly Treasury auctions.
In the shorter time horizon leading up to the end of QE3, that is 2003 to 2014, central banks took down, on average, the equivalent of 90 percent of the annual increase in notes and bonds. All that mattered to the price-insensitive central banks was monetary and exchange rate policy. Stunning.
Greenspan’s Bond Market Conundrum
The charts and data also explain what Alan Greenspan labeled the bond market conundrum just before the Great Financial Crisis (GFC). The former Fed chairman was baffled as long-term rates hardly budged while the Fed raised the funds rate by 425 bps from 2004 to 2006, largely, to cool off the housing market.
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