Market Pulse: Paying The Bill
In 6 minutes, I'll explain the market’s ongoing sell-off through the lens of the important concept of Fiscal Dominance.
This issue serves as a Part II to the Market Pulse: Sugar High newsletter issue I published over the weekend.
💡 In this issue I’ll explain the market’s ongoing sell-off through the lens of the important concept of Fiscal Dominance. I think this issue contains very important ideas about our financial system today and I hope you stick around.
Before diving into the concept of Fiscal Dominance, let’s set the stage.
The market is falling. It’s been falling since the start of this month, aka the start of Q2.
What’s going on? Why is the market selling off?
One explanation for this, which I think is quite plausible (we never know for sure), is that the US government is issuing debt very differently this quarter. In the last two quarters, debt issuance was very supportive of liquidity whereas this quarter, liquidity is being drained.
Many economists agree that ever since the pandemic, when the economy was flooded with trillions of dollars of new money and debt by the US government, the government has started playing an out-sized role in the financial system.
This phenomenon is commonly referred to as Fiscal Dominance.
Collins Dictionary definition: “Fiscal is used to describe something that relates to government money or public money”.
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In the past few issues, I’ve written about:
Thinking in probabilities using probability density functions
How Yellen leveraged the trillions of dollars in the Fed’s ON RRP to fund the US government
The fascinating economies of Japan and China and how they are both boosting liquidity in the US
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Today, riding on the tail winds of massive fiscal spending during the pandemic, the Biden Administration continues to spend large amounts of money to fund two major proxy wars while stimulating the domestic economy.
Some economists argue that government spending is out of control at this point. Just 3 days ago, Biden announced yet another spending plan to forgive another $7.4B in student debt.
The US government has to issue $10 trillion in debt this year ($7 trillion to refinance existing debt and $3 trillion to fund the government).
Two direct outcomes of this out-sized government spending and debt issuance, as it pertains to Fiscal Dominance, are:
Economic growth (i.e. GDP growth) is now a lot more dependent on government spending.
US Treasury auctions (debt issuance) are now setting the tempo of the financial markets.
Using this framework, it can be argued that a significant change in US Treasury debt issuance is a major reason for the ongoing stock market sell-off.
Treasury Bills are just like cash
Before I dive into what changed with US Treasury debt issuance this quarter, I should quickly explain how US government debt (aka US treasuries) works.
Some of you are already very familiar with this so I’ll be quick (but comprehensive for those that aren’t familiar).
US government debt comes with different maturity dates, ranging from 1 month to 30 years.
Debt with different maturity lengths have different interest rates. A good rule of thumb is that the longer it takes for the debt to mature, the riskier the debt, and so the higher the debt’s interest rate should be (this is not always the case, the market determines long-term debt interest rates).
Debt that matures in under a year are known as treasury bills (t-bills), debt that matures between a year and 10 years are known as treasury notes (t-notes), and debt that matures at or after 10 years are known as treasury bonds (t-bonds).
The market treats t-bills, t-notes, and t-bonds very differently.
Why?
Because the longer it takes for a debt security to mature, the riskier it is. To put this in practical terms, a rise in interest rates by 1% will cause the value of a 30-year bond to fall by 30% while the value of a 1-year note will only fall by 1%.
From this example, it’s easy to see that t-bills are a lot less risky than t-notes and t-bonds.
Because of this lower risk, the financial system often treats t-bills like cash.
T-bills are so low risk that highly regulated money market funds with very strict liquidity requirements can invest in them.
Paying the Bill
As I’ve discussed in previous newsletter issues, the US Treasury’s larger-than-usual issuance of t-bills in the past year has been how the government was able to sidestep market volatility, despite having to issue a record amount of government debt at a time when long-term interest rates are high and international demand for US debt is low.
There are two main reasons for this:
Money market funds have $2 trillion in excess funds that they’re lending to the Federal Reserve through its Overnight Reverse Repo (ON RRP) facility to earn yield. T-bills pay a slightly higher yield than the ON RRP and since money market funds can invest in them, a lot of this money was directed to buying t-bills when the US Treasury started issuing more of them last year.
Since t-bills act almost like cash in the financial system, the issuance of t-bills doesn’t reduce liquidity as much as the issuance of t-notes and t-bonds. It can even be argued that t-bill issuance actually boosts liquidity in the system. Cash that yields 5%?! Who could say no to that.

The key takeaway here is that t-bill issuance to fund the government is very supportive of liquidity in the financial system.
At the very least, t-bills don’t drain liquidity and in some cases, they even add liquidity.
With all this exposition out of the way, let’s get back to the main point of this newsletter issue: why is the market selling off?