Treasuries
You don’t need a graduate degree in accounting to understand how the federal government’s budget works. In fact, the graphic at the header of the his post makes it pretty simple. It’s from JP Morgan’s “Guide to Markets” and in case you are having trouble reading it, here’s the link:
Guide to the Markets | J.P. Morgan Asset Management
For simplicity I’ll break it down for you. We Spend about $7 Trillion dollars a year. Here’s what we spend it on:
-$1 trillion (970 billion) or 14% on Interest.
-$1 trillion (917 billion) or 13% on Defense
-$1.6 trillion (1.581trillion) or 23% on Social Security
-$2.5 trillion (2.353 trillion) or 34% on (medicare, medicade, and veterans healthcare)
-$1.2 trillion (1.190 trillion) or 17% on “Other”
That’s it in a nutshell. I rounded them a little to keep it simple (as you can see), but that’s what the government spends money on every single year.
The government also makes money, in fact we pull in something in the neighborhood of $5.2 tillion. Here’s what that looks like:
-$2.7 trillion ($2.656 trillion) or 38% on Income Tax
-$1.7 trillion ($1.748 trillion) or 25% on Social Security withholding
-$0.5 Trillion ($452 billion) or 6% in corporate tax
-$200 billion ($195 billion) or 3% in customs duties (NEW!)
-$183 billion in “other”
At first glance, two questions jump off the page for me. One “wow, we’re short $1.775 Trillion dollars every single year?!?” And Two, “what’s going to happen to that “interest” bucket in expenses if we keep running this enormous deficit?”
Let’s table those for a second, because there are some other issues to address. First, I’d be remiss if I didn’t point out the “other” column in expenses. “Other” is exactly what is sounds like, it’s everything else. To my republican friends who think we can balance the budget by just cutting some safety nets, or social programs, or literally everything not listed above, you can’t cut it ALL for a number of logistical reasons we hopefully don’t need to explain (planes need to fly, highways need maintenance, etc.). But let’s assume you did cut it all. Everything from the post office to the national parks, no federal reserve bank, no supreme court, all gone… Do that and it’s still going to leave with you with a deficit that’s around $700 billion too wide.
And to my democrat frinds who think we can just raise taxes to fix the problem, you can see the issues there as well. Maybe you’re thinking corporations aren’t paying their fair share? But the US already has a particularly high corporate tax rate among other global economies, and even if you look at just developed economies, we’re still only about the middle of the pact (1). If we raise it much higher companies have an obligation to their shareholders to move their operations overseas. Microsoft is a company designed in Seattle by Americans, where is it based? Ireland, which probably not coincidentally has a very low corporate tax rate. Even if they didn’t move an increase in their tax rate would have a huge and negative impact on their stock prices, stocks owned by a great many Americans in their investing or 401k plans. It would also have an impact on employment, as those companies would have less money to hire workers. But again, for the sake of simplicity, let’s assume you double our corporate tax rate. Ok sweet, we’re still $1.3 trillion short. Want to raise income tax? On who, exactly? Depending on their home States high income earners already pay over 50% tax rates in America. You mathmatically couldn’t double their rates even if they were willing to work for free. Want to start taxing poor people? Good luck winning any election. You could start to creep into Middle class taxes which is where most politicians seem to get pretty creative. But still, you can see there’s not a lot of extra room there either. Let’s assume for hyperbole that you were able to raise taxes on incomes by 50%. Which would absolutely be felt by everyone across the income spectrum (2.656 trillion times 1.5 = 3.984 trillion), you’re still short by about 447 billion.
“Customs” is a bit interesting, and could easily be its own paper (working on it). It’s interesting because it’s new, we’ve never had it as a revenue source. Some argue it’s just a hidden tax (we pay higher prices for goods, so importers can pay the government for it’s tariffs), and some argue it’s a great way to make other countries pay their “fair share”. I’m more of a math guy than a politics guy, so for now let’s table that debate, and instead focus on its percentage, which is extremely small. You’d have to raise them 10x to cover the deficit, and as I hinted to above, doing so would have tremendous ripple effects that I plan to cover in a later paper.
So where does all this leave us? It leaves us with a deficit that’s growing, and that pesky “interest” column will continue to ensure that it grows exponentially, making the imbalance dramatically worse over a very short time period. In fact, if we currently owe 38 trillion ish (2) and we’re adding about 2 trillion every year by way of the deficit, that interest bucket alone will be 50 billion dollars more next year just from interest (3). And that’s some back of the envelope math with you can’t really use because rates are higher not lower as they’re refinancing their securities. The point I’m trying to make is that this problem is getting dramatically worse every year. And will continue to do so until we can stop the bleeding and balance the budget. And balancing it will take more than political blaming from either side, and it will likely require a lot of really tough decisions. Either cutting social security (as elderly people’s lives are getting more expensive), or the military (as the world is clearly not getting any safer), or Medicare, Medicaid, and veterans benefits (which by the way has been where a lot of the recent cuts have been focused, to no avail). Or on the revenue side, we’d likely need to see considerable tax hikes which would have a severe impact on the economy. Likely leading to layoffs, and less personal income for American’s from higher taxes. Switching to my opinion here, because I don’t think there is a solution.
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I think instead what you’ll see, is a deficit that continues to grow. No one wants to elect the “let’s tighten our belts” president, so they’ll continue to spend and blame. Financing the growing Debt by issuing more and more treasuries. Like all markets, when you overweight supply, you have an equal inverse relationship with demand. As demand for the debt goes down, they’ll continue to raise rates to make them more attractive, paying those rates will make the problem harder and harder until our debt goes the way of all debt and we have to default on it.
From there a couple things will likely happen. Either the deficit snaps close instantly making a lot of these tough decisions for us, and likely not in the direction that we want them to be made. Social security checks won’t get mailed out, military troops won’t get paid, millions of Americans won’t get the healthcare they need. And whoever stops getting paid our interest, will likely not be happy. The vast majority of which are American’s themselves. Other pension funds, investment companies, insurance companies, and even the federal government itself. All will stop getting their interest payments. This will cause our ability to finance debt in the future to deteriorate further, making it much harder for us to grow going forward.
The second thing that will happen is the thing I’m much more curious about. You see we use the treasury rates for a lot in finance. In fact, it’s called the “risk free” rate because of how safe it was always perceived to be. When you try to determine valuations of a fixed income instrument, it’s very common to use the difference between the “risk-free” rate (treasuries) and whatever else you’re measuring. This “spread” is very useful for determining valuations. If high yield corporate bonds are historically 4% above treasuries (spread) what happens when they stay the same price but treasuries rates become unreliable? If you demand a higher interest rate on treasuries, would you then demand a higher rate on all bonds? Or would you prefer to own a bond from say “Apple” or “Microsoft” because it’s perceived as “safer” than treasuries.
An even more important question to ask is “how do I protect my portfolio against this problem?” The first issue is that while the situation is bleak, it’s not a 100% chance that the government doesn’t figure this out. Maybe they do the combination of rasing taxes and cutting spending gradually. Maybe they find a new isolated group that is under taxed, like space travel, or a new type of farming, similar to what happened when the budget was briefly balanced in the 90’s from all extra internet growth/tax revenue. Maybe large groups of the elderly are thinned out by another pandemic or maybe an alien comes to earth with pockets full of gold, who knows? Point is that no matter how probable a default is, it’s not a guarantee. The other much more likely issue is that they could just inflate the problem away. If you owe everyone 38 trillion dollars, why not make a dollar worth half as much, now you basically only owe 19 trillion. It’s not a great solution, it would have tremendously negative implications for the economy, but way less severe than a global default of the world’s reserve currency. Again, there are some exit ramps, which from an investment standpoint, makes it a little harder to handicap.
The other issue is that even if we know WHAT will happen, we don’t exactly know WHEN it will happen. If this happens in 40 years, who cares? Even if it happens in 4 years, what will the return be that we lose out on while we’re hiding in our bomb shelters? The key is to find hedges that a) still perform ok in all of our exit ramp situations, b) aren’t time dependent, because we don’t know the time this would occur, and c) most importantly, would survive the financial armageddon that would ensue from a treasury default. Let’s start by ruling investments out, treasuries are the first to scratch off the list. If they’re what is potentially going to default, they’re definitely out (obvi). What about stocks? They’d probably do ok, right? Keep in mind that most major recessions are caused not by equity bubbles, but by credit bubbles. And 38 trillion dollars (or whatever it is by then) is going to have a gargantuan effect on most assets. And equities which are backed by companies earnings would of course not be immune. Unemployment would spike, GDP would fall dramatically, companies wouldn’t have anyone to sell anything too. I’d imagine they’d have a huge selloff.
What about other bonds? Maybe Microsoft or Apple or some super safe company? Well, the largest “corporate” bond fund in America is Vanguards intermediate corporate bond fund (Ticker:VCIT) which ironically does still own some treasuries in it (4), and even if it didn’t, the spread problem still exists from above. We have no idea how the market would view other debt if the world’s “safest” debt does go bankrupt. Also, in the inflation problem, this could get pretty ugly pretty quickly. No one cares about a nice safe 5% yield from Apple if inflation is at 9% (hypothetically). So I think we can rule out most debt, which the exception of private credit with floating rates. But even then, the rates would have to be backed by companies that can stomach large increases (as their rate floats) in their debt servicing costs. Which is a very small list of companies. I think we can rule this out in a hyperinflation world also.
Ok, what about Crypto Currency? That’s an interesting one. Maybe we just all switch to a new currency, maybe bitcoin replaces the dollar? It’s possible, but there’s zero evidence to suggest we’d all just abandon the US dollar in favor of some digital algorithms. Also, who knows which currency we’d switch to? Bitcoin is the biggest, but others are better at transaction efficiency, or have lower volatility. Or maybe the government adapts their own digital currency and outlaws bitcoin. You can see how choosing the wrong crypto currency would be calamitous in this untested environment. Not to mention, if 38 trillion dollars is sucked out of the economy, I can’t imagine that wouldn’t have an effect on the digital asset that does nothing.
Ok, so what’s left? In my opinion not much. I think real assets are your best bet. Find things that are finite and in heavy demand regardless of market disturbances. People need power, so I like infrastructure. People need to eat, so I like farming, and also commodities. Computer chips still need gallium and houses need copper, and all the other wonderful things we pull out of the ground that have supply controlled by their scarcity. The problem is that commodities are hard to buy. In fact, most commodity funds hold futures contracts (a piece of paper that says you can guy x commodity at y time for z price) and futures contracts are back by cash held somewhere. Now follow me here, but I have a billion dollars worth of commodity futures, that’s usually backed by cash I have somewhere worth considerable less than a billion (margin accounts) and in most cases, that “cash” is held in, wait for it, treasuries…. Dang, they got us again. SO a smarter play would be to own stock in Miners. Own the companies that pull safe needed things out of the ground. It’s not a perfect solution, but in a world where we can’t depend on treasuries to keep the financial peace, I think they’re the best house on a bad block.
Do I think you should run away from treasuries today? No. But I think you need to start increasing the weight in your portfolio to things that are less susceptible to a problem we can see coming from a mile away. Buy infrastructure, buy miners, buy farmland. You can hold your exposure to stocks, since we don’t know when (or if) the treasury default will show up, and you’d likely miss a lot of Equity appreciation if you leave too early. But start to draw down your exposure to treasuries as soon as you can. Even if they don’t default, they’re becoming less attractive by the day. And any problem being managed by politicians will always blow up the same way… eventually.
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(1) https://taxfoundation.org/data/all/global/corporate-tax-rates-by-country-2024/
(2) https://fiscaldata.treasury.gov/americas-finance-guide/national-debt/
(3) 970,000,000,000/38,000,000,000,000=0.0255 add the 2 trillion to 38,000,000,000,000 = 40 trillion. Keep the same rate of 2.55% on 40 trillion is 40,000,000,000,000*0.0255=1.02×10¹² or 1,020,000,000,000 - 970,000,000,000=5×10¹⁰ or 50,000,000,000.
(4) https://advisors.vanguard.com/investments/products/vcit/vanguard-intermediate-term-corporate-bond-etf?cmpgn=FAS:PS:XX:LF:20250101:GG:DM:LB~FAS_VN~GG_KC~BD_PR~LF_UN~FixedIncomeProduct_MT~Broad_AT~None_EX~None:None:NONE:NONE:KW:IntermediateTermCorporateBondETF&gclsrc=aw.ds&gad_source=1&gad_campaignid=21752162092&gbraid=0AAAAADyd_RXR1xUmEpDgYOQeHZFYwcrkB&gclid=Cj0KCQiAjJTKBhCjARIsAIMC449NOTAwobF7ie9280MzvfgbBfGcOnBALH0D5rWhUYXPi7PR4yt1bKcaAuOVEALw_wcB#overview
