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Dear Fed: The Chickens Are Finally Coming Home To Roost Part II

This week, the market had a strong rebound at the beginning of the week, raising hopes that the bear market is nearing its end. The Ivory Hill RiskSIGNAL is still negative, and the trend is still downward. We are sitting on over 85% cash today. Since this rally had minimal impact on the trend, even over the short term, it is likely that short sellers are covering their bets and perhaps some speculators looking to make a profit drove this surge in stock prices.

By the way, there are some fantastic deals out there. If you were to buy today, would you be happy about it in three years? I'll use odds to answer my own question. I would suggest that there is a 90% or better chance that the market will be higher in three years.

When you look at stocks like Qualcomm, Inc., Wells Fargo, and even Microsoft and Apple, they are looking like a generational buying opportunity here.

We need to be patient and wait until the market tells us when the trend has changed.

We are in a bear market where market conditions are signaling that the probability of a further selloff is more likely than not.

We have a significant amount of cash on hand, and we are sitting in a great position to benefit from a fresh bull market. And I guarantee a new bull market will come; the only question is when.

Our business cycle forecasting model shows the following:

  • The US will have slowing economic growth until Q2 of 2023.

  • The US inflation target is 4.83% by Q2 2023 (still a problem for the Fed).

The takeaway here is that we could be sitting in this position for a while, so set that expectation for yourself.

This graph caught my eye. It demonstrates that midterm years have a significant downturn, but returns a year later are excellent.

I have been saying for well over a year now that the US has a major debt problem.

  • The markets are currently concentrating on the effects of a short-term increases in interest rates.

  • The market for U.K. pension funds was on the verge of collapse.

  • The solvency of one or more of Europe's big banks is in question.

  • Institutions lack the time to respond and hedge themselves when borrowing costs fluctuate quickly, as they have done over the previous few months.

  • They abruptly overexpose themselves, which is when the system starts to break.

Let's focus on the long-term.

Debt accumulation and its servicing costs move considerably more slowly and aren't always as obvious. Although its influence is more gradual than immediate, it is present and may represent the greatest market danger of all.

Jerome Powell has been unrelenting in his commitment to raising interest rates until inflation is under control. We can argue all day about how successful this strategy will be given that many of the current inflationary pressures are supply-driven, but it is indisputable that this cycle will significantly accelerate both increased debt servicing costs as well as add more debt to the balance sheet.

Here is the status of current outstanding Treasury debt.

Of the $31 trillion total Treasury balance, this represents around $24 trillion. The remaining $7 trillion is a broad basket of securities we won't get into that today.

The weighted average interest rate on outstanding debt has climbed from 1.35% in February to 1.80% in August (September data not available yet). Given what has occurred to interest rates in 2022, it would not appear to be a significant difference on the surface, but this change alone has increased the government's yearly interest expense by about $140 billion. That's not a meaningless number by itself, but the biggest risk is what will happen if the Fed decides to keep interest rates high for a long time.

The most significant adjustment in interest rates has occurred at the ultra-short end of the yield curve - Treasury bills and floating rate notes. Floating rate notes obviously adjust their rates regularly, and changes in the interest rate environment are swiftly reflected. Because this group represents less than 3% of the balance sheet, the 270 basis point increase in rates has a small impact. T-bills mature in less than a year, so existing debt is quickly replaced by newly issued debt with higher interest rates.

The average for longer-term debt is still pretty much the same, but the rate on Treasury notes is starting to go up.

Here is where there is the most risk exposure is:

  • Government debt has an average remaining term of roughly five years until maturity.

  • We're already about a year into the repricing of bonds, which means that if interest rates stay where they are, we could have a financial disaster as soon as 2026.

I think Treasury yields will go down once the Fed stops raising rates, but a lack of rate cuts on the other end of this cycle could keep yields higher for longer than the market might like.

And let's not overlook something crucial that has to do with the table above. It only continues till the end of August.

Take a look at what happened to Treasury rates in September.

Yields on 3-month Treasury notes increased by 40 basis points. The increase in long-term rates amounts to around 70 basis points. The above Treasury balance profile doesn't account for this, but it does suggest that the average interest rate on outstanding debt will continue to rise.

Current 5-year Treasury rates are around 4%. Treasury note average rates are around 1.5%. If the average rate on Treasury debt increased by 250 basis points, what do you think would happen? Interest payments on the national debt cost the government approximately $700 billion last year alone. That figure would increase by a factor of two, reaching about $1.3-1.4 trillion. That's assuming the debt stays at $31 trillion, by the way. It's evident that won't happen, and the cumulative cost of interest will keep climbing as a result.

About $4.4 trillion was collected in taxes by the government in 2021. Under the rising-rate scenario, if that figure holds, the government would have to pay out one-third of every dollar it receives to pay for debt. This has already started, and even if it doesn't reach 250 basis points, the government still faces hundreds of billions of dollars in added interest expense over the next few years.

That is why I believe another round of QE is almost guaranteed at some point. This QE would be employed not to save the economy from systemic failures, which is a real risk, but because the government cannot afford to make the minimum payment on its massive debt.

It is imminent. The amount paid in interest is only rising, and this trend is expected to continue for at least the next few fiscal quarters. The government's revenue base will not be rising any time soon until Congress begins adopting some big tax rises (not politically profitable if you are trying to win an election), and this is not likely to happen. It is anticipated that the United States will have annual budget deficits of at least one trillion dollars until 2030.

If this trend continues, a bear market will look like nothing more than a minor inconvenience. We're talking about a a global financial catastrophe. If no significant budgetary changes are made, another round of QE will only push the problem farther down the road.

We are going to sit on our pile of cash and take small nibbles at macro opportunities until the Ivory Hill RiskSIGNAL tells us where the bottom is.

And remember – the one fact pertaining to all conditions is that they will change.

Feel free to reach out to me and use me as a sounding board.

best regards,

Kurt S. Altrichter, CRPS®

Fiduciary Advisor | President

Direct: 952.828.5336

—Written 10.7.2022


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