US Federal Debt Is Rising Risk Factor For The US Treasury Market
By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com
TMC Research advised in August that growing concerns about the federal government’s fiscal outlook will likely be a crucial issue for the next occupant of the Oval Office (“Will Rising Federal Debt Constrain The Next US President?”, August 23, 2024). There are signs that the Treasury bond market is starting to agree.
As discussed in our previous note, US federal interest payments as a percentage of the economy (GDP) continue to rise sharply. Data through the second quarter of 2024 show that payments rose to 3.8%, the highest since 1998. Although payments are still well below the near-5% peak in the 1980s, the sharp spike of late is beginning to alarm economists and, it seems, bond investors.
The US 10-year Treasury yield jumped to 4.3% in mid-day trading today (October 31). As recently as mid-September it was roughly 3.6%. Robust economic data is surely part of the reasoning for the higher yield, but the fiscal outlook may be resonating as well. What’s changed? One factor may be the recognition that a new president and Congress is coming to town and stump speeches focused on the growing fiscal burden are conspicuous by their absence.
Meanwhile, several metrics look worrisome. The US debt-to-GDP ratio, for instance, has climbed sharply in recent years. After spiking to over 130% during the pandemic, this ratio has eased but continues to print above 120%--sharply above the pre-pandemic history. No one’s sure about which ratio marks a clear tipping point that will unleash blowback. Japan, for example, has a higher percentage of debt relative to its economy than the US for some time but so far Tokyo’s had no problem selling bonds or servicing its debt. Presumably the US, with the world’s reserve currency and other attributes that accrue to the world’s lone superpower, has more headroom than Japan for debt capacity.
One proxy for assessing how closely the Treasury market appears to be paying attention to fiscal matters: the correlation between crude oil prices and the 10-year yield. The price of oil and the 10-year rate have generally tracked one another closely in recent years. The reasoning: higher oil prices imply higher inflation and vice versa. Accordingly, a number of analysts in recent days have pointed out that the slide in oil prices has been accompanied by a run-up in the 10-year yield – an unusual divergence in the past couple of years. The Treasury market’s effective dismissal of the recent disinflationary shift in crude suggests that fiscal risk has overtaken inflation risk as a key driver of yields.
Another clue that points to a stronger influence from fiscal risk: the recent rise in the 10-year term premium, based on a model developed by Federal Reserve economists (“An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates” by Don H. Kim and Johnathan H. Wright). Since mid-September, the estimated 10-year term premium has increased sharply—leading the 10-year Treasury yield higher. The implication: investors are demanding higher compensation for potential changes in interest rates in the future for intermediate/long-term maturities, a sentiment shift that’s arguably related to heightened concerns about fiscal risk.
Consider, too, that the Treasury market’s implied inflation forecast has jumped recently, based on the yield spread for the nominal 10-year rate less its inflation-indexed counterpart. On September 10, this spread was slightly above 2%, rebounding to 2.34% on October 30.
The sharp rise in the price of gold is also considered a warning. On October 30 the precious metal traded slightly above $2,800 an ounce for the first time in history. The metal is widely considered a hedge against fiat currencies (the greenback in particular) and ill-advised government decisions generally.
To be fair, there’s a degree of speculation in assigning a relationship between Treasury yields and fiscal risk. Mr. Market doesn’t explain his actions nor are there obvious rules for when and where a tipping point lies. But it’s clear that the government’s fiscal profile, from several perspectives, has become increasingly topical for markets, and not in a good way. Meanwhile, the Congressional Budget Office (a non-partisan agency that analyzes the government’s finances) predicts that the debt-to-ratio will continue to rise over the next several years.
The solutions to the mounting red ink come in three basic flavors: raising taxes, reducing spending, or some combination of both. Exactly when and how the government addresses the challenge remains unclear, at least until after next week’s election.