As US debt worries rise, markets look to central bank to ease liquidity

(Originally published Oct. 28 in “What in the World“) This is turning into a wild week for markets.

The U.S. Federal Reserve is due to decide tomorrow whether to cut rates. That’s always something of a cliffhanger for investors, even when investors are 96.7% sure the Fed is going to cut by 25 basis points. But this week’s decision comes amid quarterly earnings reports for Big Tech: five of the Magnificent Seven stocks that dominate the stock market will give the latest gauge of whether AI is a mirage or not. Google, Meta, and Microsoft are due to report the same the of the Fed rate decision, with Amazon and Apple due to announce earnings the next day.

What investors will be looking from the Fed is not just a 25bps rate cut, and not even clues about another in December—they’re 94% certain that’s coming, too. Where they’re divided is whether the Fed will continue cutting in January or not. So, they’ll be parsing the Fed’s announcement for any suggestion of how it feels about persistent inflation and the weakening job market. Inflation in September clocked in above the Fed’s target at 3%. And the job market isn’t being helped by the government shutdown and Trump’s attempts to layoff federal employees while it’s out of commission.

But they’re also looking for the Fed to help alleviate some serious trouble in the market for cash. Regular readers may recall that there were signs of a liquidity crunch in money markets back in September, when big sales of U.S. Treasuries sucked so much cash out of the market that the cost of borrowing overnight using Treasuries as collateral—the Secured Overnight Financing Rate (SOFR), jumped to a two-month high.

Then a couple of weeks ago it emerged that not only has the government been on a borrowing spree, but that the Treasury Dept. under Secretary Scott Bessent has been trying to push down 10-year bond yields by shifting the bulk of government bond sales to shorter-term T-bills. By thus reducing the supply of new 10-year bonds, the Treasury is hoping to push up their price and lower the effective yield—a commonly used gauge of faith in the U.S. government and economy.

While the shift to short-term borrowing may lower the government’s long-term borrowing costs, it doesn’t change the fact that it’s borrowing more. And it doesn’t change the fact that rising U.S. debt issuance is sucking cash out of the economy. As explained in this space earlier this month:

…the shift to short-term debt raises Washington’s refinancing risks while sucking cash out of the economy. How? New Treasuries must be paid for in cash the day of settlement. Some $40 billion of such payments came due on Wednesday alone. Another $23 billion are due today.

Transfers of that magnitude put pressure on the amount of cash, or liquidity, that banks have available. When they run low, they turn to the Fed for short-term, usually overnight loans, ordinarily by selling the Fed a repurchase agreements (in which the Fed buys a security from a bank that promises to buy it back after a certain period of time at a higher price, i.e. a rate of interest—essentially borrowing money from the Fed, which thus injects cash into the financial system. But when banks ran into a liquidity crunch in 2021 during the pandemic, the Fed launched a new Standing Repo Facility (SRF) that banks can tap for emergency cash on top of that.

On Wednesday, when the $40 billion payment crunch hit, banks borrowed $6.5 billion from the Fed’s SRF — an indication that liquidity got pretty tight. And the interest rate on overnight repos climbed to 4.36%, its highest since the deadline for corporate tax payments last month created a similar liquidity squeeze.

What this suggests, in a nutshell, is that the government’s soaring funding costs are starting to overburden the U.S. financial system, potentially squeezing out its ability to maintain normal financing to the private sector.

This trend, The New York Times reminds us, is being exacerbated by another bond market tactic by the U.S. Federal Reserve. For the past few years, the Fed has been trying to gradually sell off the $9 trillion in bonds it amassed during its efforts to revive the U.S. economy with negative interest rates—buying bonds with dollars it conjured out of thin air. So far, the Fed has sold off $2.4 trillion of those assets, in the process pulling that much very real cash out of the economy, a process known as “quantitative tightening.” As a result of these factors, the spread between 1-year contracts on the SOFR and the Fed funds rate has climbed to a record, suggesting that investors expect the liquidity crunch to get worse.

Sucking cash out of the market makes less sense, though, now that the Fed is trying to support the job market and sustain economic growth by lowering interest rates. So, Fed chair Jerome Powell said earlier this month it might be time to end quantitative tightening. Sure enough, Reuters reports, some investor bought a massive number of derivative contracts last week in the forward market for interest rates, betting that SOFR will drop back below the Fed funds rate by next month.

Essentially, the bet is that the Fed will announce the end of quantitative tightening when it announces its rate decision tomorrow, thus removing one of the big brakes on liquidity in markets.

The problem remains that U.S. government debt is getting far too large relative to both the economy and Washington’s ability to service it. The International Monetary Fund now projects that gross U.S. government debt will, driven by an annual deficit equivalent to more than 7% of GDP, rise to 143.4% of GDP by the end of this decade, exceeding that of Greece and Italy.

Other signs of fragility are also growing in the wake of autoparts company First Brands’ bankruptcy. The Bank for International Settlements now warns that ratings on private loans may be inflated. That may come as little surprise, but it raises the risk that these private loans may go bad despite high ratings and that investors may start dumping them en masse—triggering “fire sales.”

Private credit in the U.S. has been booming, led by private equity companies, investment banks, and insurers. That boom also created opportunities for new entrants in the credit-rating business to challenge the big three agencies—Fitch, Moody’s, and S&P. These smaller agencies would issue ratings on private credit that were then also private, available only to the borrower and its lenders.

Concerns abound that First Brands’ failure could puncture a bubble in private credit, or non-bank lending, that could in turn imperil the real economy. The IMF has recently raised new warnings about the risks to the financial system posed by the expansion of financing beyond traditional banks, saying that authorities should expand oversight of credit funds, hedge funds, and private equity. The IMF said banks in the US and Europe have a $4.5 trillion in loans to these non-bank financial institutions, representing 9% of their total loan book.

The logic of private lending—in other words, loans made without the transparency of a bond offering or the scrutiny of a conventional bank—is that corporate lenders know business, so who better to assess whether a business can repay them? But assessing risk is what banks do, using models to assess not just the risk of an individual business repaying, but how broader industry and economic trends may affect that business and the many other borrowers the bank has.

That’s why the IMF has been so concerned about the shift in credit away from banks after global regulators moved to clip their wings after the global financial crisis. Not only do non-bank lenders like pension funds and private equity firms not have the same understanding of systemic risk that banks are supposed to have developed (and still screw up even so), but they don’t have banks complex methods of ensuring that they remain solvent should that risk throw one or even dozens of their borrowers into default.

Then there’s the biggest wild card of all: Trump. Trump is touring Asia this week, and on Day One conjured up some cap-feathering deals to lower tariffs: one on goods from Cambodia, Malaysia, Thailand, and Vietnam; another is said to be imminent with China. And as with Trump’s previous trade announcements, these are likely to be full of fanfare, short on details, and long on disappointment.