By Mike Dolan
LONDON (Reuters) – Even if a 16-year high of 5% proves a top for 10-year Treasury yields after the latest bond blowout, it’s hard to imagine a dissipation of debt market angst as mounting deficits and debt service costs prompt a rethink of budget math and risk premia.
The mix of U.S. congressional dysfunction and slow-burning primary government deficits – themselves likely spurring an exceptional U.S. growth performance and a “higher for longer” interest rate view – has unnerved bond investors into seeking a risk premium that may balloon debt projections ever higher.
Speaking at this week’s global finance meeting in Riyadh, HSBC boss Noel Quinn warned of a potential “tipping point on fiscal deficits” for a number of countries across the world.
“When it comes, it will come fast,” he added.
Watching the spiralling of benchmark government borrowing costs this month, it’s not hard to see how quickly the numbers get out of hand.
Even though many bond analysts have been scratching their heads as to what triggered the sudden fright beyond the ongoing hiatus in Congress, the re-emergence of the shadowy “term premium” demanded for holding long-term bonds to maturity has clearly been one factor capturing the rising uncertainty.
According to New York Fed estimates, that’s now at an eight-year high of almost half a percentage point – having been negative for much of the past decade. Other models put it even higher.
But the sheer weight of Treasury debt sales – with another $141 billion in two, five and seven-year maturities on sale this week alone – is weighing on the market as the Federal Reserve continues to wind down it bloated balance sheet of bonds.
Even as private investors still appear happy to load up on more bonds at these elevated yields, the supply pressure going forward seems increasingly daunting as marginal buyers like the Fed and overseas central banks back away.
JPMorgan analysts reckon the profile of Treasury funding becomes “problematic” in 2024.
The huge $1.9 trillion of short-term bill sales this year – exaggerated by the building Treasury coffers around serial debt stop episodes in Congress – has been largely funded by money market funds switching back to bills from the Fed’s reverse repo overnight facility.
As a reflection of that, use of the latter has dropped by more than $1.5 trillion this year to just over $1 trillion now.
But JPMorgan points out that, with no change to budget projections, bill sales are set to collapse to just $200 billion next year – meaning the rest of this year’s maturing bill mountain has to be refinanced with longer-term bond sales.
Overall, Treasury needs to refinance up to $17 trillion of its existing debt in the next two years.
And some analysts fear the uncertainty of next year’s funding crush is filtering out the steepening yield curve via the term premium.
‘DOOM LOOP’?
The resulting jump in nominal 10-year yields by almost 100 bp since the start of last month – with no material change to Fed policy rate expectations through the end of next year – reflects something of a supply shock coming down the pike.
And a “doom loop” of sorts is completed if the effects of this yield shock are extrapolated to already scary budget math.
Most economists revert to the independent Congressional Budget Office’s long-term deficit and debt forecasts for guidance and the picture painted at midyear is stark.
The CBO sees a sustained U.S. primary deficit, which excludes interest costs, of more than 3% of GDP from 2023 through 2053 – more than twice the 50-year average.
But it saw net interest costs on that sustained level of deficits and rising debt almost tripling to 6.7% of GDP in 30 years time – bringing debt-to-GDP ratios to more than 180% from this year’s 100%, already near the historic peaks of World War Two.
That’s spooky enough, until you start to factor in the recent yield spike and or a return of the term premium to 60-year averages of 150 bp.
Currency fund manager Stephen Jen points out the June CBO report assumed 10-year yields of 3.9% – this year’s average so far but a full percentage point below current rates. And assumptions for 2033, 2043 and 2053 – at 3.8%, 4.1%, and 4.5% respectively – are all now far below prevailing yields too.
What’s more, Jen added that the CBO did not assume any term premium – simply putting 10-year yields roughly equal to its projected nominal GDP view.
“To the extent that a meaningful term premium emerges, the debt service burden of the U.S. would be commensurately heavier,” he wrote earlier this month.
Goldman Sachs has warned that when debt servicing costs spiked like this in the 1980s, Washington was forced to shrink the primary deficit to offset and an adjustment akin to that enacted in 1993 may be enough to square the circle over five years.
The problem is there’s little or no hope of that happening over the next year – with a gridlocked congress and a 2024 election looming – and possibly not for another five years.
And the picture in Europe is not much better – with euro budget rules still not reinstated since a pandemic suspension amid wrangling about reforms. Deficits in the bloc’s biggest debtor Italy are set to surge to more than 5% and 4% of GDP respectively this year and next and borrowing rates are rising.
Even though Britain’s credit outlook was lifted to stable last week by Moody’s (NYSE:), Finance Minister Jeremy Hunt – who’s due to update his budget next month – said debt servicing costs were set to rise by up to 30 billion pounds ($36.5 billion) a year due to higher rates and claimed that was “clearly not sustainable”.
Tipping point or not, there’s a danger the market is starting crystallise the problem it fears most.
The opinions expressed here are those of the author, a columnist for Reuters.
(By Mike Dolan X: @reutersMikeD)
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