Transcription
What happens when a government borrows so much that it cannot raise taxes enough to pay for its debt, but it also can't lower interest rates for itself without unleashing hyperinflation? Well, it turns out governments have a playbook exactly for this situation. It has been run many times by many governments, many times throughout history, and it requires a de facto merger of the central bank and the central government. In our case, that's the Federal Reserve and the US Treasury. And don't worry, this is not hypothetical. In fact, the US government has already done this once in recent history. And they did this when they were in the exact same fiscal position they are in right now. And they are putting together the plan to implement this yet again. And I'm going to explain to you exactly why they're doing this and why Trump's new pick for the Fed chair, Kevin Worsh, is exactly precisely for this purpose. And if this is your first time here, my voice doesn't normally sound like this. I apologize. It'll be better next time.
Recently, markets got rocked by something Kevin Walsh said about calling for a Fed Treasury accord, which has been stirring debate about what exactly that means. Well, luckily, we can look at exactly what that means. The first thing you need to understand is the relationship between how much debt the US government has compared to the size of the economy. You can see prior to World War II spending, this ratio was down underneath 40%. But as a result of all the spending that happened during the war, the debt to GDP ratio skyrocketed to 121%. But the US government was able to successfully delever. While they did not reduce their total amount of debt, they did reduce the amount of debt that they had relative to the size of the economy, bringing it down to a low of just about 30% by the early 1980s. But as you can see, the last 40 years have reversed that deleveraging and the United States government is yet again in a position with its debt that is unsustainable. It's unsustainable because number one, there's simply not enough money in the economy to be able to tax enough to pay for its bills. That means the US government has to run very large deficits every year. In other words, borrow extra after they've spent everything that they've taken from you in taxes. But as a result of that borrowing, interest rate costs for them are fairly high. But they can't just tell the Fed to lower interest rates because then you run the risk of unleashing inflation yet again. And it turns out this is exactly the problem that the US government was facing right after World War II.
Cuz following World War II, the Federal Reserve engaged in something called yield curve control for the United States. They did this from 1942 through 1951. Now, you guys know just as well as I do that there is only one outcome of this controlled demolition. We are going to see continued long-term debasement of the dollar. And if you want to know exactly what I'm doing to not only protect myself, but profit from this forced wealth transfer, then I need you to mark down this date on your calendar, February 22nd, 700 p.m. Eastern time. That's this coming Sunday evening. And that's because I'm going live on Zoom to detail a unique trading strategy that allows you to profit in the commodity space, all without using margin or futures or leveraging your account or anything risky like that. In fact, it's incredibly easy once you know what to do. I'm going to teach you things like number one, why I believe the commodity space is set to explode this year, 2026. Number two, how I am leveraging this space and already have been leveraging this space to generate double-digit returns, triple-digit returns in my own account, sometimes within the matter of just a few months. And number three, I'm also extending a special invitation to take a small group of people under my wing to teach them for the next year about how this trading strategy works. If that sounds like something that you're interested in learning more about, go ahead and click on that link in the description below. Attendance is completely free, but remember spots are limited, so don't wait to sign up. I hope to see you there.
So, what exactly is yield curve control? Well, right now, interest rates on government borrowing for 10 years, 20 years, or 30 years are largely influenced by free market forces. Now, I need to be clear what I mean by that. It means that institutions, banks, companies, people are constantly buying and selling these bonds and that supply and demand pushes the prices up or down. Which is why you see something like a 30-year Treasury with yields that have been rising consistently. However, we see the opposite when we look at the short end of the curve. When we look at something like six-month T bills, we see interest rates have been falling. The reason for that is because the Federal Reserve sets interest rates at the shortest end of the curve. The only interest rate that they actually outright control is the Federal funds rate. In other words, what banks pay to borrow from each other overnight. Because that debt is all the way at the shortest end of the yield curve, it does have an influence on other short-term debt like six-month T bills. But it has very little effect on long-term debt like 30-year Treasuries. In fact, if the Federal Reserve keeps those short-term interest rates too low, the Federal Government is able to spend money into existence faster, unleashing inflation, which means the free market forces acting on things like the 30-year Treasuries will actually push interest rates higher to compensate for that inflation.
However, back in the late 40s, the Federal Government needed to pay for the war, and they had a lot of borrowing that they needed to do. And so what the Federal Reserve did was they helped the US Treasury finance that war debt by pegging interest rates on short-term Treasury bills at a fixed interest rate. And then they also capped interest rates on longer-term Treasury bonds. In other words, the Federal Reserve made sure that no matter where the US government was borrowing, interest rates would not rise past a level they could afford. They exercised outright control on interest rates across the entire curve. Something that they are not doing right now. Now, the way that they did this was by buying an unlimited number of treasuries in order to keep those yields suppressed, which meant if there was extra selling or the government issued extra debt, the Federal Reserve might have to absorb more or all of it in order to keep those yields down. And that is exactly what happened. The Fed had no choice but to acquire whatever quantity of bills the Treasury issued. And so, the Fed had to acquire large amounts of Treasury bills, which had low investor demand, and their balance sheet ballooned.
Now, it's interesting because this is very similar to what happened in 2020 and 2021. Even though the Fed was not engaging in outright yield curve control, the quantitative easing they were doing looked very similar. If you look at what interest rates did starting in 2020, they collapsed from over 2% down to a little over 1%. And we see something even more extreme with 10-year treasuries collapsing from around 1.8% down to about 0.6%. Again, we find a similar but more exaggerated example with 2-year yields going from around 1.4% down to almost zero at 0.14%. And so, despite the fact that the Federal Reserve was not targeting specific interest rates across the yield curve, we see the same effect happened. Yields everywhere got smashed and the Fed's balance sheet ballooned from $4 trillion to a high of almost $9 trillion. But, as you'll notice, the Fed's balance sheet started to wind down from there starting in 2022. and is now only at $6.5 trillion. They've also raised interest rates and the reason for this is because of inflation. Well, what happened back in the 40s? Turns out the exact same thing. In order to maintain the yield curve control, the Fed was forced to let its balance sheet balloon as well as the total supply of money. However, inflation was the greatest concern to the Fed at that time. Between 1946 and 47, the CPI hit 17% and then from 1947 to 48, it was 9.5%. By February of 1951, inflation had reached 21%. At that point, the Federal Reserve had had enough. They were no longer going to engage in outright yield curve control anymore. That allowed the US government to borrow and spend money into existence as much as they wanted because the Fed needed to get a handle on this out-of-control inflation.
I hope you're starting to notice at this point, yeah, history doesn't repeat, but it does rhyme. Debt to GDP ratio hits 120%, the Fed starts to monetize a bunch of the government's debt, and then inflation gets out of control, and the Fed gets worried about reigning in that inflation that they caused in the first place. Same thing happened in the 40s and 50s. Same thing is happening right now. And so in 1951, the US Treasury and the Federal Reserve reached an agreement that they now call the Treasury Fed Accord, echoing exactly what Kevin Walsh is calling for, a new Fed Treasury Accord. It's no secret that Kevin Worsh has been very critical of all the QE, all the low interest rates, all the ballooning asset bubbles caused by the Fed. However, he was instrumental in getting this process started during the financial crisis. We've seen time and time again people who outside are critical of the way the Fed does things. Once they get into position, they do the same exact things. We saw it with Powell. We saw it all the way back to Greenspan. And I don't think Kevin Walsh is going to be any different specifically because the Treasury Fed accord in 1951 had them issue a statement that said they would be able to assure the successful financing of the government's requirements and at the same time minimize monetization of the public debt. Just for reference, here is 1951 and you can see the government's debt to GDP ratio continued to collapse from there for the next 30 years.
There are exactly four ways that a government can reduce its debt to GDP ratio. Number one, it can run a surplus. That means cutting spending, stopping borrowing, and paying down the debt. I don't know if you've been paying attention to government spending over the last year, but it is not slowing down. It is increasing. Despite campaign promises, there is no austerity. It will not happen. They are spending more. So, that option is out the window. Option number two is to just outright default. If the US government were to outright default and just decide it was not going to pay back any of that debt and essentially its obligations could go to zero, which means that its debt no longer exists. So the debt to GDP ratio is fixed. However, this would also collapse the entire global financial system. And they're probably not going to do that, at least by choice. It's possible that political gridlock during a time of a government shutdown could lead to a temporary delay on treasury payments and a technical default, but other than that, it is highly unlikely that the federal government will just default on its debt. Number three is for the economy to grow faster than the debt grows. And this was actually a large part of why the debt to GDP ratio fell during the '50s, '60s, and '70s. There's a massive increase in productivity following the war. All those men came home and actually started working and producing. All those resources and materials stopped getting sent for destruction, started getting used for real production again. Many women entered the workforce and technological revolutions that started increased productivity as well. Now today there is one main thing people are looking at as the hope to have massive economic growth going forward into the near future and that is AI automation and robotics. Although I would argue that energy deregulation could fit in there as well. I'm not going to get into that in this video because that's a topic for another time. But technology always has the potential to make an economy far more productive than it was before. We just don't know if it's going to happen before it actually happens.
Which leaves the final option, which is inflating the debt away. If the government can borrow newly created dollars in order to pay for its expenses and pay its debt, if the government can roll over its existing debt into lower interest rate debt, then the purchasing power of those dollars goes down. Meanwhile, the size of the economy measured in dollars goes up. This was a large part of why the deleveraging happened from the 50s through the 80s and a new accord or a merger of the goals between the Federal Reserve and the Treasury. If that can happen right now, then the federal government might be successful in inflating the debt away. Just be warned, that means they're unloading the cost of that debt onto the economy. Yes, they delever, but there's no free lunch. Somebody pays for it, and it's going to be you and me through higher prices. But how does that work when War is calling for a Fed Treasury accord similar to the one that happened in 1951 where the Federal Reserve directly stopped its yield curve control? Well, number one, it could come from a remix of the Federal Reserve's balance sheet. Right now, the Federal Reserve holds very few T bills relative to things like mortgage back securities and long-term bonds. And so in order to more closely match the overall market, the Federal Reserve could outright get rid of all of its mortgage back securities, replace that with T-bills, or just grow the amount of T-bills in its portfolio. That would temporarily give the US government a fresh source of easy money to borrow from.
But the second source that I think is the most likely is bank deregulation. This is something I've been talking about for a while now. A Fed Governor Steven Moran recently wrote a paper and gave a speech about deregulating the banks. Now, without getting into the technical jargon of this, that literally just means allowing the banks to buy an unlimited number of US treasuries. Right now, they're governed by something called the supplementary leverage ratio, the SLR, and that restricts how many US treasuries they can buy. During 2020 and 2021, that was temporarily removed and banks went crazy on treasuries. They bought a ton of them. That was one of the reasons why treasury rates fell. However, in 2021, that temporary suspension ended and banks were forced to offload a bunch of deposits. It's why so much money went into money market funds. So much bank reserves went into the reverse repo facility. It was kind of a disaster. And so, if the new Fed administration in coordination with the Treasury want to achieve the goal of returning the Federal Reserve to its historical impact on the markets, but also allow the US government to borrow anything it needs. It's going to have to happen with bank deregulation. The Federal Reserve could normalize its balance sheet while banks take up the slack in the financial markets. Bank deregulation happens with coordination between the Fed and the Treasury. So both Scott Besson and Wars are going to be needed for this. And so while the incoming Fed chair might look like somebody who is going to put downward pressure on the markets is going to make it harder for the federal government to borrow what it needs. When you read in between the lines, it's exactly the opposite. Prepare for higher prices of goods and services and assets combined. Prepare for higher interest rates for you and I even though the government will be able to borrow at a rate lower than the rate of inflation because they're pulling out and dusting off that playbook from the 1950s and the results will likely be similar. As always, thank you so much for watching. Have a great day.