Debt funding, inflation, and gold

Even though the Fed is expected to reduce its funds rate in a week’s time, the inflation outlook is worsening rapidly, which is why the dollar is weakening and gold rising.

Governments are attempting to contain their long-term debt funding costs, which are due to a combination of a lack of investor demand and bond yields which have risen sharply in recent years. The extra funding cost of long-term maturities over short-term rates is illustrated in the US Treasury yield curve in the chart above. In the case of US treasuries, auctions with longer maturities tend to be disappointing. Doubtless, if longer term funding is used to ensure the debt maturity profile remained containable with respect to maturity roll-overs, long-end yields would be considerably higher.

This explains why the Fed approved a move to reduce the supplementary leverage ratio imposed on big bank balance sheets so long as the extra balance sheet space is invested in treasuries. However, this will only increase bank demand for short-term debt, mainly T-bills maturing in less than a year. But it is worth remembering that this finance is bank credit and not investor-sourced, making it inflationary. But reducing the supplementary leverage ratio is only part of the story.

Almost certainly, the Fed will reduce its funds rate by .25% in a week’s time. Under political pressure, further rate cuts can be expected. This will reduce the cost of T-bill funding even further. A win-win for Trump —or is it?