U.S. Debt: Growing Rate Disparity

Most macroeconomic analysis relies on low-frequency data, such as national accounts which are published quarterly. Workforce data and earnings are more frequent, rolling out on a monthly basis. However, over on the monetary side of the economy things move much faster: money supply is published weekly and interest rates on U.S. Treasury debt – technically the price of money – is updated on a business-day basis.

Thanks to their high frequency, monetary variables make for excellent instant-message variables on where the economy may be heading next. It is important not to put too much emphasis on them – far too many pundits draw way too big conclusions from daily or weekly swings in M1 money supply or in interest rates – but when taken for what they are, these variables do tell us a few things about what is to come in the less-frequent variables.

For those of us who are interested in the relationship between government debt, inflation and macroeconomic performance, the trends in Treasury rates are quite telling of investor confidence. One of the best ways to assess that confidence is go compare the interest rates on Treasury bills and bonds. The former are short-term papers, the latter long term; in Figure 1 we report the average daily rate on, respectively:

  • Bills with a maturity of one, two and three months; and
  • Bonds with a maturity of 10, 20 and 30 years.

Since late last summer the rates on bonds have been creeping upward, and are continuing to do so (left vertical axis). By contrast, rates on bills are trending downward (right vertical axis) and have done so longer than bond rates have been trending upward:

Figure 1

Source: U.S. Treasury

This growing rate gap is caused by weakening confidence in the U.S. government’s ability to honor its debt obligations over the long term. Investors are not abandoning U.S. debt, but they prefer to hold short-terms papers instead. They are even willing to marginally sacrifice yield: the compound-interest yield on a package of 1-3 month bills is marginally lower than the one-year average yield on a 10-30-year bond package.

The small yield difference is the risk premium for holding longer-term U.S. debt, and as Figure 1 explains that premium has been growing over the past six months. This, again, signals weakening confidence in U.S. debt over time, which spells trouble for Congress, already in the coming weeks and months.

Another interesting variable is the annual growth rate in M1 money supply. This growth rate was at extreme levels already mid-last year, due to the monetization of coronavirus stimulus spending. However, the monetary expansion took another leap toward the end of 2020, the reason being the roll-out of stimulus outlays that had not gone out the door during the previous fiscal year (which ended September 30). As reported in Figure 2, that spike plateaued in December, where we could have hoped that it would remain. It did not: there was yet another spike – albeit a small one – right after new year. It is too early to tell whether or not that was just a one-time bump in the money supply, but there are two reasons to be modestly hopeful that our outrageous monetary expansion may be at least taking a break. The first one is the noticeable spike in the ten-year bond rate:

Figure 2

Sources of raw data: Federal Reserve (M1); U.S. Treasury (Bond rate)

Interest rates on government debt rise for a small number of reasons: weakening confidence in the ability of that government to pay its debt obligations; inflation, which erodes the value of coupon-based earnings; and tightening money supply. The last variable is due simply to the fact that when money supply goes tighter, bond prices fall (they are in excess supply) and the coupon yield rises as share of the price.

It is already clear that the first two variables – confidence and expectations of inflation – affect investors. The third variable could actually be starting to affect the bond market: according to the latest updates from the Federal Reserve, total M1 money supply is actually contracting a little bit. Behold Table 1:

Table 1

Source: Federal Reserve

M1, $bn
2020-10-19       5,482.6
2020-10-26       5,726.1
2020-11-02       5,874.8
2020-11-09       5,493.9
2020-11-16       5,534.3
2020-11-23       6,206.4
2020-11-30       6,865.1
2020-12-07       6,495.8
2020-12-14       6,540.8
2020-12-21       6,800.6
2020-12-28       7,038.2
2021-01-04       7,044.4
2021-01-11       6,558.7
2021-01-18       6,609.7

There is a regularity in M1 supply fluctuations that can produce these effects – see the trough early December for comparison – so we should not get our hopes up. But the tapering-off is larger than it has been recently and could, maybe, hopefully, be the beginning of the end of the Great Big Money Craze of 2020. Again, this is more of wishful thinking than a hard fact, but keep an eye on this ball as it moves forward in the next couple of weeks.

What we do know is this: if the M1 supply starts growing again (on an annual basis) during February, and if that growth is combined with a growing rate disparity between bonds and bills, then we can safely conclude that the rate disparity is driven by weakening confidence and expectations of higher inflation.