Why the Government Debt Crisis Will Blow up Before We Even Get to Default

The Fed’s fight has become much more complex this month. Inflation is fighting back harder all of a sudden, while the US debt ceiling is putting bond markets and banks at considerable extra risk by driving bond yields up even faster than the Fed was doing. This extra thrust is happening just as the Fed was trying to end its rate increases and even as additional banks are poised to collapse from the already-high bond rates. The situation appears to be cascading into a nuclear market meltdown.

When I published The Daily Doom two days ago, the headlines in that edition seemed to call the latest inflation report two ways, some highlighting that inflation is down a little, some saying it is up. The truth depends on what individual components you look at, which finely parsed indices of inflation, and whether you are looking at month-to-month or year-on-year. So, I’ll sum the real inflation situation and banking situation up simply in this intro and then analyze the overall crisis in more detail in the following sections because you have to understand how serious inflation is first in order to understand the critical situation the Fed (and all of us thanks to the Fed) is facing. (Patrons who get access to The Daily Doom, may want to drop straight to the next section because they already saw most of this intro as the opening editorial on the 10th unless they want a refresher.)

The bottom line is that inflation is a tiny bit less significant overall than it was a month ago, but the rate at which inflation has been dropping has also almost stalled. That is a not what the Fed (or any of us) wants to see. What you see in many of the measures of inflation that were given in this Wednesday’s report is a tiny blip downward in CPI for the month of April that is nowhere near as significant as the drops we have been seeing in prior month’s.

Nevertheless, I think the Fed is likely to pause in its rate hikes, at the next meeting for the simple reason that we are now in exactly the month at which I have believed the Fed would pause since the start of the year. That is because, months back, the Fed telegraphed the likelihood of three more 25 basis-point hikes and then a pause, and those hikes are finally now all in with the Fed’s last meeting on May 3rd. Meanwhile, the Fed is assuredly far more concerned about the banking crisis it has created than it is about to let on because the Fed’s fears, when expressed, become self-fulfilling prophecies.

While the majority of mainstream financial writers did not believe the Fed would even stay the course with its telegraphed plan, I was certain the Fed would because inflation would not move close enough to its target during the first four months of this year for it to do any less. Now we know that as an historic fact. I doubted the Fed would be able to go further than that, however, before serious trouble began to surface, as has also now become historic fact. I’ve said, for at least a year, the Fed will tighten until something really bad breaks, and with three banks down and out and another (PacWest) in the running, clearly something really bad has broken.

Not doing its final telegraphed hike at its last meeting, however, would have indicated the Fed was scared enough that its policy was causing damage to force it to change course; therefore, it would stay the course on doing all it had indicated was likely and then step back as it had forecast because another 25 basis points wouldn’t add much to what they have already done anyway. That allows the Fed, at its next meeting, to do nothing and say, “This is the point where we have been telling you we would likely pause” (with the usual “data-dependent” phrase thrown in there somewhere). Their mantra about fine, upstanding banks of robust solvency will continue so the Fed doesn’t lurch people into doubting their entire policy of the past year(s). Their position, in other words, will be that everything is going according to plan!

With some banks actually crashing while others lean in on cue because of Fed policy and GDP resting on the threshold of a second dip into “technical” recession and Fed policy lagging by, at least, six months, I think they’ll take a breather and hope their plan works. (That raises the question of whether the plan always included the casualty of blowing up a few banks, which is a little like the military saying, “We meant to blow up a few of our own forts for the greater good of the cause.” Umm … Ooookay. But these forts — these banks — had a lot of people in them.)

However, the big slowdown in the rate at which inflation is falling means the Fed’s battle with inflation is actually far from over, so there is just about zero chance the Fed will start to lower its interest target even in a full crisis. Investors need to forget the Fed pivot — pure market fantasy by completely self-deceived and delusional investors, which has endured for almost a year. In spite of how that mirage has always failed to materialize, nothing I’ve written to any one of the pivot prognosticators on Seeking Alpha has cleared the swirls of opium smoke from around their heads.

My own mantra has been that a move to lower rates was never going to happen until the economy is destroyed to the point where lowering rates won’t help stocks anyway, which also means even more banks will be blowing up. (And a stop now in rate hikes with an eventual lowering of rates someday down the road is not a “pivot” even when that drop comes. Not even close.)

Once the economy and banks lie in greater ruin, the Fed will face the start choice of which of its two children it wants to kill. It will have to decide between 1) crashing its economic recovery and its banking system into utter rubble by holding rates where they are, throwing more rubble on the heap, or 2) throwing gasoline on hot inflation by lowering rates to try to “save” the economy and bail out banks, thus incinerating the value of their own money and public trust by taking the first big step down the path to hyperinflation.

Either choice is a wicked path, and I don’t know which they will choose; but that is precisely the trap the Fed began laying in for all of us with its extreme inflation policy of the past decade wherein it tried to fix a debt-based crisis during the Great Recession by doing all it could to make debt cheaper, enticing as many people down into deeper caverns of debt as possible before burying them alive with inflation. All of that was done as a cheap fix for the last crash to avoid the hard work of rethinking and resetting our economic fundamentals that are a disaster in numerous ways that are now closing in on us. You cannot live on a diet of pain pills.

The worst effects of Fed policy accumulated when the Fed continued massive money printing at the government’s behest (while pretending it is independent from the government it serves and whose congressional charter gives the Fed all its power) in order to keep funding government Covid stimulus programs for far too long, even as it kept telling the world the US economy was “strong and resilient.” If “strong and resilient,” why on earth the need for more stimulus?

That was an immediately apparent self-contradiction. Those who can think — such as readers here who inquire beyond the regurgitated pablum of mainstream financial writing — knew the cognitive dissonance in that policy was a railroad bound for high inflation. It likely was driven by pressure to enable the federal government to continue its absurd supersized, deficit, stimulus spending.

The result we see, as the Fed now tries to back out of its massive mistake by raising interest to fight the inflation it fueled, is that banks are going insolvent here, there, and everywhere. Sure, only three have popped like nasty pimples on Powell’s face, with a couple more starting to redden and swell; but the deeper truth — as several commentators laid out in The Daily Doom headlines on Wednesday — is that thousands of US banks are technically or “potentially” insolvent, meaning the only thing saving them from deep trouble is the Fed’s determination that they will not be required to mark the value of their assets or collateral down to market (as they would have to do in an honest banking system in order to treat them as real — i.e., drawable — reserves).

Given the long lag between Fed policy changes and the effects of those changes, however, more banks will collapse, as the problem of devaluation in assets and collateral will get worse for several more months, even if the Fed stops in its tracks.

Worse than that technical backdrop, which becomes a existential problem for those banks only if they face a run on deposits that they cannot meet, is that deposits keep fleeing from smaller banks to the top-tier banks that the Fed and feds have chosen to protect with infinite deposit insurance that is not available to banks that are generally good banks but are not in the privileged too-big-to-fail bankster category. This Fed policy assures the too-big-to-fail banks will grow much bigger by design as they 1) scavenge depositors away from smaller banks and 2) devour those smaller banks at bargain rates when they fail because of that scavenging.

Within this cannibalistic realm of soon-to-crash smaller banks and overindulged behemoth banks that are supported by the new insurance policy of Fed & Feds, Inc., a new crisis is forming around the nation’s national debt.

(Headlines supporting what was said in this intro were contained in The Daily Doom on Wednesday when the CPI report came out, so supporters of my writing got the first summary view.)

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