Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed's Silent Fiscal Squeeze
Transcript
- Lucas: Look at the headline from Friday: the U.S. budget deficit has swelled to almost two trillion dollars for fiscal 2026. That is a twelve percent jump in a single year. It sounds like pure politics, but it creates a structural problem for the Federal Reserve that most listeners aren't connecting to their portfolio. Luna: Right, because when the government borrows that much, it floods the market with Treasuries. And if demand doesn't keep up, yields have to rise to attract buyers. Is that the specific squeeze you're seeing? Lucas: Exactly. The math is brutal. We are seeing wholesale prices jump six point three percent annually in September, which is the biggest gain since twenty twenty-two. Meanwhile, the ten-year yield is hovering around five point one percent. The Fed can't cut rates aggressively when the cost of funding the entire federal apparatus is so high. Luna: So the deficit isn't just a line item; it's an active constraint on monetary easing. If they cut rates, they risk fueling that inflation spike further. Lucas: Precisely. And here is where it gets weird for the listener. The markets are actually pricing in a hold for October. Kevin Warsh wrote a piece suggesting he might surprise everyone, but the consensus is stability. Yet, look at the Nasdaq. It's down four point two percent over the last five days. Investors are nervous about where this debt trajectory leads. Luna: It feels like the bond market is screaming while the equity market is whispering. Why do you think the stocks are taking such a hit despite the rate hold expectation? Lucas: Because the discount rate for future cash flows is rising. When your ten-year Treasury is sitting at five point one percent, tech valuations get crushed. You don't need a rate hike to hurt growth stocks; you just need long-end yields to stay elevated due to fiscal supply. The Federal Reserve is effectively being held hostage by the Treasury Department's spending habits. Luna: That is a sharp way to put it. Hostage to fiscal policy. But wait, before we dive deeper into the bond market mechanics, I want to pause for a second. If walking through the economy with us has made something click, or even just helped you feel less anxious about the headlines, consider supporting the show directly. Lucas: We keep this network ad-free and independent precisely because these topics matter. If you find value in the analysis, you can support us at buy me a coffee dot com slash fexingo. It helps us keep digging into the data. Luna: Yeah, it really does make a difference in keeping the coverage deep and free. Thanks for listening. Lucas: Let's go back to that Treasury supply issue. The IMF recently warned about messy forecasting, and the Treasury dismissed it. But dismissing the warning doesn't change the reality of the issuance schedule. Every month, the government needs to roll over existing debt and borrow new money. Luna: And who is buying all this paper? Foreign central banks have been reducing their holdings in many cases. So domestic investors have to step in. Lucas: That is correct. And domestic investors, like pension funds and insurance companies, have options. They can move to shorter-term bills, which pushes money out of the long end of the curve. This keeps those ten-year and thirty-year yields sticky. Even if the Fed cuts the overnight rate, the long end stays high. That is a partial transmission failure of monetary policy. Luna: So the Fed pulls the short-term lever, but the long-term rates refuse to budge. That must be incredibly frustrating for policymakers who want to stimulate growth. Lucas: It is. Look at the Core PCE price index. It came in at one hundred thirty point five in August. It's still above the two percent target. If the Fed cuts rates now, while the deficit is exploding and long yields are high, they might not get the stimulus effect they want. They might just get more inflation. Luna: So we're stuck in a bind where cutting feels dangerous, but holding feels like ignoring the slowing labor market. What is the historical precedent for this? Lucas: Not much, honestly. In the nineteen seventy-five period, we had stagflation and fiscal deficits, but the dynamics were different. Today, the global dollar system means foreign demand for U.S. debt is elastic, but not infinite. The recent drop in the VIX suggests some relief, but the underlying pressure on yields is structural. Luna: I remember reading that the Interest on Reserve Balances is currently at three point nine zero percent. Does that act as a floor for short-term rates? Lucas: It absolutely does. The effective Fed Funds rate is at three point seven five percent, but the daily rate is ticking up to three point eight eight percent. The IORB at three point nine zero sets a hard ceiling for where banks will lend to each other. If the Fed tries to cut below that without adjusting the IORB, liquidity could dry up or become volatile. Luna: So they can't just lower the headline number. They'd have to manage the corridor carefully. Which makes any sudden move very risky. Lucas: Exactly. And remember, the PPI was hot earlier this week. Wholesale prices jumped six point three percent. That suggests input costs are rising for businesses. If those costs pass through to consumers, Core CPI will tick up again. The Fed sees that and says, 'Wait, we're not done yet.' Luna: But the consumer isn't seeing that same urgency. The ten-year breakeven inflation dropped to two point three two percent. Markets think inflation is coming down. Lucas: There is the divergence. The bond market is betting on disinflation, but the PPI and CPI data are telling a mixed story. The Fed is likely focusing on the sticky components—services, wages, housing—while the bond market looks at energy and goods. This mismatch creates volatility. The Nasdaq drop reflects that uncertainty. Luna: It feels like the Fed is trying to steer a ship while someone else is dumping cargo overboard. The fiscal side is destabilizing the monetary control. Lucas: That is the best analogy I've heard all week. And the Treasury Department knows this. Their dismissal of the IMF warning wasn't just arrogance; it was a deflection. They know they need the Fed to keep rates manageable to service that two-trillion-dollar deficit. Luna: So there is implicit pressure on the Fed to not hike, and perhaps even to cut eventually, to help the government finance itself. Is that 'fiscal dominance'? Lucas: That is exactly what economists call fiscal dominance. When monetary policy is subordinated to fiscal necessity. Right now, we are in a gray zone. The Fed claims independence, but the constraints are real. If they hike rates to kill inflation, borrowing costs for the U.S. government skyrocket, which could trigger a debt spiral narrative. Luna: And if they cut too early, inflation reignites. It seems like the October hold is the only safe play for them right now. Lucas: For October, yes. But the question is November and December. With the deficit growing and PPI hot, can they afford to cut in December? Or will they signal a 'higher for longer' stance to anchor those long-term yields? Luna: If they signal higher for longer, the stock market might sell off even harder. Tech stocks are already down four percent. Are we looking at a correction? Lucas: A correction is possible, but a crash requires a crisis of confidence in the debt. We aren't there yet. The Dow is actually up slightly today. The S&P is down two percent. It's a rotation, not a panic. Investors are moving from growth to value, away from duration sensitivity. Luna: So they are selling the things that hate high rates and buying the things that can handle them. That makes sense given the yield environment. Lucas: Right. Energy, financials, maybe industrials. These sectors benefit from a steeper yield curve or stable rates. Tech needs cheap money. And cheap money is expensive right now because of the fiscal bleed. Luna: It's fascinating how the budget report changes the investment thesis. Most people ignore the deficit when picking stocks, but it's literally setting the price of capital. Lucas: It is. And if you look at the RUT, the Russell twenty small caps are down two point six percent. They rely heavily on floating-rate debt. Higher long yields often correlate with tighter credit conditions, which hurts smaller borrowers more. Luna: So the spread between large cap stability and small cap vulnerability is widening. Is that a trend we should watch going into Q4? Lucas: Absolutely. Watch the credit spreads. If the Treasury issuance overwhelms the market, credit spreads will widen. That hits small caps and highly leveraged corporates first. The Fed can print money, but they can't force private lenders to lend if they fear default. Luna: Which brings us back to the core tension. The Fed has the tools, but the fiscal tailwind is pushing against them. Do you think the Fed will eventually lose control of the long end? Lucas: I don't think they lose control, but they lose influence. They set the short end. The market sets the long end. If the market decides long yields must be five point five percent to accommodate the deficit, the Fed can try to push them down with quantitative tightening reversal, but it costs them credibility. Luna: So it becomes a game of chicken. The Fed vs. the Bond Vigilantes. Who blinks first? Lucas: The Bond Vigilantes rarely blink until the chart breaks. And right now, the chart shows yields resisting the downward pressure. So the Fed likely holds in October, signals caution in November, and maybe cuts in December if the data softens. But it won't be a dramatic pivot. It will be a slow, painful adjustment. Luna: Slow and painful. That sounds like the perfect description for the current macro landscape. Thanks for breaking that down, Lucas. Lucas: Anytime. The key takeaway for you is to stop watching just the Fed Funds rate. Watch the ten-year yield and the deficit trajectory. Those are the real drivers of your wealth in this environment.