Simon and Garfunkel used to sing: August, die she must, The autumn winds blow chilly and cold, September, I’ll remember,
A love once new has now grown old. Are the U.S. treasuries following a similar fate?

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The amount of outstanding U.S. government debt has now grown to slightly more than one year’s GDP.

When Treasury securities mature, the government repays them while simultaneously borrowing roughly the same amount again—often at different maturities and interest rates. On top of that, it issues additional debt to finance new deficits. As a result, the total keeps growing.

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This year as well, the Treasury is holding auctions in several rounds throughout the year, but both the number and size of the auctions happen to be particularly concentrated around this time. That is one reason movements in U.S. long-term interest rates are now attracting increasing attention.

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Quite apart from the Treasury market, the financial condition of America’s nonbank financial institutions has also become a focus of concern.

After the 2008 Lehman crisis, large U.S. banks were subjected to layer upon layer of regulation—including the Volcker Rule—designed to prevent them from using their own funds for speculative trading. But there are numerous financial institutions collectively known as “nonbanks” that are not subject to the same regulations. They sometimes even operate with money or financing provided by major banks, investing funds in relatively speculative assets.

When interest rates rise, stock prices tend to come under pressure. Nonbanks heavily exposed to speculative equities can therefore run into serious financial trouble. And if that begins to undermine confidence in the major banks that have lent money to them, the result can be a seizure in financial markets: everyone starts wondering whether everyone else may be on the verge of collapse, and nobody wants to lend.

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Thus, the U.S. financial market currently faces two potential sources of crisis: the Treasury market and the nonbank financial sector. If a crisis originates in one or the other, the effects on the dollar and stock prices will differ. If the two erupt at roughly the same time, movements in the dollar and equities could become considerably more complicated.

So I discussed the outlook with ChatGPT. What makes Chat interesting these days is that it no longer seems merely to retrieve information from somewhere. It studies the material, puts the pieces together, and constructs its own outlook.

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Author:

Dear Chat, suppose U.S. interest rates rise further and it becomes increasingly difficult for the Treasury to sell its debt. What happens then? What happens to stock prices and the dollar?

Separately, could concerns about the creditworthiness of nonbanks cause the financial system to seize up? And if so, what would happen?

During the 2008 Lehman crisis, what happened to interest rates, stock prices, and the dollar over the following two years?

And what happened during the two years following the 1985 Plaza Accord?

Give me a brief answer in bullet points.

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ChatGPT:

1) If U.S. Treasuries become increasingly difficult to sell and long-term interest rates rise further, treasury prices would fall and long-term yields would rise. Mortgage rates, corporate bond yields, and the cost of corporate borrowing would also increase.

Stocks would generally fall. High-P/E AI and technology stocks would be particularly vulnerable, because higher interest rates reduce the present value of future earnings.

The dollar could initially rise, as capital flows into the United States in search of higher yields.

But there is a critical distinction. If interest rates are high simply because inflation is high, that is one thing.

If yields begin rising because investors are losing confidence in U.S. government debt itself, the dollar could eventually turn downward. That is the most dangerous point.

In other words, the bad scenario would be falling Treasury prices + falling stocks + a falling dollar—a U.S. version of a “triple decline.”

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2) Now what if a crisis of confidence in nonbanks occurs at the same time?

That could undermine confidence in the major banks that have lent money to those institutions, producing a credit contraction in which “the money is there, but nobody wants to lend it.”

The assets held by the nonbank financial sector have been estimated at as much as $86 trillion (!), with perhaps around $22 trillion potentially exposed to risk.

In mid-August, one hedge fund—part of the nonbank sector in the broad sense—collapsed, prompting financial regulators to conduct an on-site investigation. This demonstrated the authorities’ growing concern about what may be lurking inside the nonbank financial system.

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3) During the 2008 Lehman crisis, interest rates initially plunged.

The federal funds rate stood at 4.25% at the beginning of 2008, but by December it had been cut to 0–0.25%.

Stocks nevertheless collapsed. The S&P 500 fell about 57% from its autumn 2007 peak to its March 2009 bottom.

It then staged a spectacular rebound, rising roughly 80% from the bottom by the end of 2010.

Surprisingly, the dollar initially rose after the crisis erupted.

Investors around the world rushed into cash and U.S. Treasuries, and the dollar’s effective exchange rate rose by roughly 12% during the second half of 2008.

In other words, even though the crisis originated in the United States, investors bought dollars.

From the spring of 2009 onward, however, as the panic subsided, the safe-haven rush into dollars reversed and the dollar weakened.

So the basic pattern of the 2008 crisis was:

credit collapse → stock-market crash → temporary dollar rise → massive Federal Reserve easing → sharp decline in interest rates → stock-market rebound and dollar decline.

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4) The two years following the 1985 Plaza Accord

(This was an entirely different story.)

In September 1985, the G5 governments deliberately agreed to push down the dollar.

The dollar fell from around ¥240 to the dollar to the ¥120 range by the end of 1987—almost a 50% decline.

U.S. stocks, however, rose substantially. The stock-market boom continued from 1985 through the first half of 1987.

Then came October 19, 1987—Black Monday—when the Dow Jones Industrial Average plunged 22.6% in a single day.

In Japan, meanwhile, the Bank of Japan lowered its official discount rate from 5% to 2.5% in an effort to prevent the sharp appreciation of the yen from damaging the economy. The resulting flow of money into stocks and real estate helped create the Japanese asset bubble that followed.

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5) What happens this time if credit markets seize up, bankruptcies increase, and the economy falls into recession?

The Federal Reserve would probably be forced eventually to cut interest rates, provide massive liquidity, and possibly resume large-scale purchases of Treasuries and other securities.

The sequence could therefore look something like this:

Act One: rising interest rates.
Act Two: a credit crisis.
Act Three: Federal Reserve intervention, followed by a sharp decline in interest rates.

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6) What about gold?

Gold is a secondary issue here, but an interesting one.

During the 2008 Lehman crisis, gold was bought alongside U.S. Treasuries as a safe-haven asset. This time, however, if Treasuries themselves were to lose investors’ confidence, gold could become virtually the only major safe-haven asset left. Gold prices have already begun rising sharply.

There is an important qualification. As happened in 2008, when market participants suddenly find themselves short of cash, they may sell whatever liquid assets they have—including gold. Gold prices could therefore fall temporarily even after an initial surge.

But once central banks, particularly the Federal Reserve, respond with massive monetary easing and large-scale purchases of government securities and other measures to contain the crisis, interest rates would fall. Gold could then begin another major advance, as in fact happened from 2009 through 2011.

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And even if the next crisis takes on the appearance of a general “sell America” movement, there is still no economic power capable of simply replacing the United States. So it would not be the end of the world.

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(The yen would probably rise sharply, which would substantially increase Japan’s GDP when measured in dollar terms. But she can hardly play the role of the US)