2023 August CAD

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-0.22% MTD
-4.23% YTD

The Next Phase of the US Government Pandemic Fiscal Stimulus

The Hangover

Dear Partners,

For the month of August, the Caravel CAD fund was down -0.22%, bringing the total net return for 2023 to -4.23%.

Following a recent strategy discussion, the team at Caravel was left asking why long-term borrowing costs had been rising over the past six months, given that inflation had been dropping precipitously and economies across the globe were slowing. We wanted to share our findings as we think they are valuable beyond our scope.

"The best way to reinforce your knowledge of a subject is to share it.”

Phil Knight (Founder, Nike)

The US government typically borrows about 15-18% of its $33 trillion debt using treasury bills (loans that mature in one year or less). When the pandemic hit, the US Treasury needed trillions of dollars fast. At that same time, the US Federal Reserve was buying trillions in bonds to lower the cost of borrowing and, in turn, to support an economy that had ground to a halt (Quantitative Easing). Treasury Secretary Janet Yellen logically decided to borrow heavily in the T-bills market to not interfere with the central bank’s stimulative program. However, she continued this for three years, well after the Fed stopped its Quantitative Easing program. She borrowed about $3.5 trillion more in T-bills than the government debt portfolio should typically have. The percentage of short-term borrowing for the US Government went from 15% to 24% of its total debt. It is generally accepted and mathematically proven that the US must balance its borrowing needs over the short and long term. Borrowing between 15-18% of its cash in the short term avoids creating liquidity risks and inflationary pressure. We won’t get into the econometrics math here; trust us on this one, and if this starts to sound a bit geeked, please read on. It could save you tons of money in the next two years and maybe give you a shot at buying long-term assets (houses, businesses, cottages) cheaper.  

For the world’s largest economy’s debt market and banking industry to function correctly, the US Government must return their short-term borrowing needs to the 15% range. What is essential to understand: The US government started replacing $3.5 trillion of treasury bills with $3.5 trillion of 5-to-30-year bonds in April 2023 and will continue until December 2024, and the free market has been adjusting long-term interest rates over the past four months to accommodate this. In this environment, that is a big nut. Our point: when you want to borrow one dollar for ten years from people wanting to lend 50 dollars for ten years, you get a nice low rate. But they ask for much more when you want to borrow 49 dollars from the same group. We understand the exercise will be about 40% complete as of September 30, 2023. 

As is often the case in markets, investors anticipated the tsunami supply of long-term credit. They are pushing up borrowing costs today by selling their holdings of long bonds in anticipation of purchasing them later at much lower prices. Supply/Demand. Very simple.

Keep in mind, in a world with trillions of dollars in debt and decades of time, this is considered a short-term event. Once the US Treasury gets its massive 33 trillion dollar loan book back in balance, we believe those who wait too long to lend (buy long bonds) will cause a material drop in long-term rates, and we will see long-term borrowing costs drop precipitously. We think those who have liquidity (cash on hand) now will be able to finance longer-term much cheaper in 12 months. Considering that the European, Japanese, and Canadian debt markets are all priced off US Debt markets, this short-term event will affect global borrowing markets over the next 12 months.

As always, we’d love to hear your thoughts. We thank you for your continued confidence and capital,

Jeff and Glen.

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