Bondholders And Taxpayers Have Shared A Remarkable Wealth Transfer

With Silicon Valley Bank’s collapse and the United States Federal Reserve’s upcoming interest rate decision, questions about the stability of U.S. financial systems are taking center stage. It is amazing how – for better or for worse – that something amazing has occurred to U.S. taxpayers over the past three years: The burden they bear on the national debt has drastically decreased. In deciding how to navigate this situation, the Fed should include in its calculations the reasons for this.

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Considering the amount of public debt that has grown by approximately $5 trillion in recent years, it may seem counterintuitive to see such a largely unnoticed development. The U.S. Treasury securities market value has gone from a high of 108% of the economy to a current value of 85% as well. There has been a significant decline in the U.S. debt burden in the last few years, and it is now at its pre-pandemic level, making it one of the fastest-declining debt burdens in history.

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Our financial situation has changed dramatically as a result of this sharp decline, but it is also the reason that we are now experiencing increased financial difficulties. In order to gain the windfall gain that taxpayers are now receiving, bondholders, including banks that have suffered big losses on their bond investments, have been compensated. This rapid decrease in debt burden needs to be examined in greater depth in order to understand what this means for the financial stability of the nation.

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There was a dramatic shift starting in the spring of 2020 which was the catalyst for this dramatic change. As federal spending increased, the economy's dollar size dropped sharply. As a result of these developments, both the tax base from which it could be paid as well as the national debt increased, raising the debt burden. Additionally, interest rates dropped to nearly zero, putting the existing Treasuries at a higher value due to their higher interest rates.

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As a result, bondholders were suddenly able to turn a profit on their Treasuries and the taxpayers had to shoulder the burden of paying off the interest payments. Altogether, these three developments caused the debt burden of taxpayers to reach 108%.

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After the pandemic shutdown, however, the dollar size of the economy quickly recovered, and by mid-2021, it had returned to its normal level, which led to a reduction of almost nine percentage points in the debt-to-GDP ratio. Inflation, on the other hand, further decreased the debt burden by 14 percentage points, resulting in a total debt burden of 85% in its current state. There are two channels through which this was accomplished. First, inflation has pushed the dollar size of the economy to an amount of $1.89 trillion above what it was before the pandemic.

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Furthermore, it is important to point out that the Fed abruptly raised interest rates after the inflation surge occurred, resulting in a significant drop in the market value of Treasuries by around $1.9 trillion. Consequently, bondholders found themselves in a much different position. In terms of inflation-adjusted terms and in comparison to other newer interest-bearing securities that paid higher rates, they suddenly found themselves holding bonds that were worth far less than they had ever expected.

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As you can see, bondholders were directly responsible for reducing the debt burden by increasing inflation in the first place. To be clear, bondholders are also taxpayers, but they are only one part of the taxpayers. Further, bondholders are more acute and visible to bondholders as a result of the loss they are experiencing than taxpayers are expecting to face a lower future tax bill. 

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In addition to the $24 trillion Treasury market, there was also another remarkable transfer of wealth away from bondholders. In addition to the $12 trillion mortgage-backed securities market and the $10 trillion corporate bond market, other fixed-income markets saw a significant loss of market value. In our opinion, this is a very important reason why banks, which own such securities, are presently in a state of stress. A recent study indicates that mark-to-market losses have overvalued these assets by $2.2 trillion in the U.S. banking system. In the event that the depositors fled en masse, many banks would not be able to cover all the claims of their depositors as a result of this loss.

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Financial stability is adversely affected by the banks' precarious position, according to regulators in the United States. The Fed chose to accept loan collateral at face value instead of market value in its new liquidity facility because the government insured all depositors at Silicon Valley Bank and Signature Bank which recently failed. A market-to-market time bomb is lurking on U.S. banks' balance sheets, according to regulators. Bondholders may not be able to afford the large transfer of wealth they have unwittingly given to their debtors.

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A number of factors have led us to this point, but probably the most important is the Fed’s rapid interest rate hikes over the past year. In light of the expectations created by low-interest rates over the past decade and the Fed’s projections just a year ago, most bondholders, including the Fed, have been surprised by the speed and scale of the hikes. In the meantime, these interest rate hikes have weakened bank balance sheets and damaged credit creation, potentially leading to another financial crisis rather than an orderly end to high inflation.

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The Fed faces challenging waters, but we can do our best to navigate through them.