A New Accord?
The 2023 Treasury Department’s Financial Report of the United States Government found that, “Under current policy and assumptions…the projected continuous rise of the debt-to-GDP ratio indicates that current policy is unsustainable.”
In other words, the U.S. Treasury Department publicly stated in 2023 that at some point something very big must change with U.S. policy to avoid launching irrecoverably over a cliff. Since 2023, that unsustainable fiscal situation has done nothing but deteriorate rapidly—and faster than expected. Even worse, that rapid deterioration has occurred despite a highly touted but fantastically unsuccessful DOGE initiative specifically aimed at righting the sinking fiscal ship.
Now, big picture macro factors such as an unsustainable fiscal trajectory for the U.S. government often don’t appear to matter for days, weeks, months, years, or even decades. Once they do, however, almost nothing else seems to matter.
In HAI‘s view, we may be rapidly approaching just such a macro tipping point. Post-Covid, markets were slowly waking to the reality of a very unsustainable U.S. fiscal position. That said, given recent events, we may now be approaching a much more dramatic smelling salts moment when markets suddenly realize just how serious (and policy dominating) the fiscal situation has become. By extension, we may also be approaching the macro moment when—suddenly—almost nothing else seems to matter.
In short, with bond yields now surging to fiscally intolerable levels in the U.S. and all across the West, the United States seems to have reached the point where Scott Bessent and the Treasury Department’s increasingly desperate need to finance the government (while avoiding a terminal debt spiral) is running squarely into direct conflict with new Fed Chair Kevin Warsh and the Federal Reserve’s increasingly desperate need to enforce its inflation mandate (or completely cede all credibility). But these two desperate needs are also in direct conflict with each other.
On the one hand, it’s devastatingly expensive (and ruinous to the fiscal situation) for the Fed to fight inflation with rate hikes due to the interest component on so much debt. On the other hand, for the Treasury to suppress yields to limit interest expenses and ease fiscal pressures fans the flames of rising price inflation.
As a result, policymakers must now choose to either defend against the government’s fiscal vulnerabilities or defend the public against inflation. Realistically, they can’t do both. In short, from a policy perspective, something has to give—and the situation is rapidly coming to a head.
Last week at the Jackson Hole Economic Policy Symposium, with inflation embarrassingly running well above target now for 65 consecutive months, or nearly 5.5 years, Warsh doubled down on previous hawkish rhetoric and clearly leaned toward endorsing a future Fed rate hike (or hikes) to bring inflation down to target—if needed.
Warsh said, “I would be hard pressed to describe broad financial conditions as restrictive… We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.”
Again, taken at face value, Warsh is clearly signaling that unless inflation makes a sudden bee-line down to target, the Fed will raise rates as needed, despite the immediate and significant negative consequence to Scott Bessent’s desperate efforts to contain yields and address the U.S. fiscal problem.
Now, in HAI‘s view, if Warsh wants to prove something, he can certainly raise rates by 25 basis points once, maybe twice—before quickly reversing to cuts again. But if Warsh engages in more serious hikes for longer to meaningfully fight inflation, he’ll initiate a sequence of events that puts a match to the powder keg of the bond market and the extremely precarious U.S. fiscal position.
Meanwhile, on the fiscal front, Scott Bessent had a very busy August, repeatedly taking action to try and keep a lid on Treasury yields to protect the U.S. fiscal situation from spiraling out of control.
In other words, while Warsh is talking tough on inflation and signaling rate hikes, Treasury is already quite clearly engaged in a form of soft yield curve control policy to keep Treasury yields suppressed.
So the question is, what are we to make of what seems like the dramatically conflicting policy trajectories of the Treasury and the Fed?
The Fed is essentially saying that it will fight inflation without regard for any damage to the fiscal problem while Treasury is already implementing a soft form of yield curve control that is inherently inflationary.
This policy conflict sets the stage for a battle over either monetary policy dominance or fiscal policy dominance. Understandably, markets seem to be quite confused.
As HAI sees it, despite the recent hawkish rhetoric from the Fed, the Treasury’s recent attempt at soft yield curve control is almost certainly the real signal to take note of. That signal suggests that the U.S. is now firmly in a regime of fiscal dominance. If so, it means the government’s massive debt and budget deficits are now hijacking the central bank’s ability to control inflation with interest rates and run independent monetary policy—whether the Fed wants to admit that or not.
Following Warsh’s hawkish speech in Jackson Hole last week, Robin Brooks, Senior Fellow at the Brookings Institute and former Chief FX Strategist at Goldman Sachs, offered his take on the confusing disconnect between recent Treasury and Fed policy signaling. In his view, market consensus (translating Warsh’s Jackson Hole speech to mean imminent rate hikes) is missing an intriguing alternative possibility altogether. HAI agrees.
As Brooks put it,
In my opinion, yesterday’s “hawkish” keynote [in Jackson Hole] was all about containing the rise in long-term yields… If that’s correct, markets are misreading what’s going on. They’re pricing greater odds for hikes in the upcoming Fed meetings, when that’s not what this was about. Instead, this was about anchoring the long end of the yield curve, i.e. this was a further step in the direction of managing the long end of the yield curve. This also means—if my interpretation is correct—that yesterday will prove to be another positive catalyst for the “debasement trade” and a weaker dollar over the medium term. We’re seeing the emergence of a new Treasury-Fed accord where the overriding goal is to keep borrowing costs down.
In other words, Brooks is suggesting that while Bessent and Treasury will actively intervene in markets to suppress long-end yields, Warsh and the Fed will likely only talk tough on inflation (without raising rates much, or at all) to try to verbally assuage inflation concerns at the long-end of the curve. Again, as Brooks said, this points to a new Treasury-Fed accord where the overriding goal is to keep borrowing costs down.
In HAI‘s view, a new Treasury-Fed accord is likely the right take. However, if that’s wrong, and Warsh does significantly raise rates to tackle inflation (again, not very likely at all, in HAI‘s view), then it would likely prove only marginally gold negative for a short time—much like the Powell-led Fed rate-hike blitzkrieg in 2022 and 2023 that preceded a subsequent breakout of gold to new all-time highs.
That’s because the United States’ unsustainable fiscal policy trajectory—referred to by the Treasury Department’s own Financial Report in 2023—is, after all, the most important story. If Warsh hikes enough to crush inflation, he will also pull forward the acute phase of an accelerated U.S. debt spiral. Ultimately, there is nothing more bullish for gold than a global reserve currency and reserve asset-issuing sovereign caught in a debt spiral.
Now, this week, a four standard deviation beat for non-farm payrolls on Friday sent rate-hike odds for September ripping back up to near recent highs. The U.S. added 162,000 jobs, up from an upward revised 21,000 last month, miles above the median estimate of 50,000.
Precious metals sold off somewhat on the news as the knee jerk reaction was that a stronger-than-expected labor market gives the Fed the green light to hike. Again, that may be true for a minimal hike (or maybe two), but, in HAI‘s view, it’s now the fiscal situation that’s dictating the ultimate trajectory of rate policy, and the fiscal situation is desperate for lower rates.
This week, following the jobs report, President Trump issued a Truth Social post that, in HAI‘s view, further supports the idea that any Fed dreams of a sustained “higher for longer” rate policy will be, very much, paddling uphill.
As the President put it:
Great jobs number just announced, breaking all estimates (except mine!) by double and triple – And you haven’t seen anything yet! EMPLOYERS ADDED 162,000 JOB IN AUGUST. Lower the interest rates because the U.S.A. is a much stronger credit than it was just a short time ago!… The Fed Board, with its great new leader, must get smart – BE PATRIOTS for a change. High interest rates put the U.S.A. at a very unfair disadvantage, and I won’t allow that to happen! President DONALD J. TRUMP
Governments don’t intentionally commit suicide, so the United States’ unsustainable fiscal policy trajectory is necessarily the most important story. It dictates that lower rates and fiscal dominance are the new reality. In HAI‘s view, a new Trump-Treasury-Fed accord where the overriding goal is to keep borrowing costs down should be assumed.
Regardless of whether Warsh hikes rates in the near-term or not, the fiscal math dictates that lower borrowing costs are a must in the intermediate and longer term. That implies that, over anything other than maybe the very near-term, a weaker dollar as a consequence of both financial repression and elevated inflation should be expected. Furthermore, that also implies that, over anything other than maybe the very near-term, crashing Fed credibility and a fully reinvigorated debasement trade should also be expected.
Weekly performance: The S&P 500 was nearly flat, up 0.09%. Gold was down 0.53%, silver was nearly flat, up 0.07%, platinum was off 1.39%, and palladium was down 3.28%. The HUI gold miners index was down 0.88%. The IFRA iShares US Infrastructure ETF was nearly flat, up 0.10%. Energy commodities were volatile and up on the week. WTI crude oil was up 9.35%, while natural gas was up 1.71%. The CRB Commodity Index was flat, up 2.47%. Copper was up 0.25%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 0.79%. The Vanguard Utilities ETF was up 0.86%. The dollar index was down 0.52% to close the week at 99.16. The yield on the 10-yr U.S. Treasury was up 7 bps on the week, closing at 4.79%.
Have a wonderful long weekend!
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
