NRPLUS MEMBER ARTICLE {W} ith yields on U.S.-government debt at or near 5 percent across the entire yield curve, the move in interest rates has been eye-popping. While the underlying concern is likely related to the nation’s deficits and unsustainable fiscal path, the proximate cause has been a surge in Treasury issuance.
On Friday, the Treasury Department released data for the full fiscal year of 2023, and found that the deficit came in at $1.7 trillion. After adjusting for the accounting of student loans and the Biden administration’s repeated attempts to saddle the taxpayer with forgiveness, the deficit effectively doubled from approximately $1 trillion in FY22 to $2 trillion in FY23.
Deficits exceeding 7 percent of gross domestic product during peacetime and outside of a severe recession are as shocking as they are fiscally irresponsible; they further suggest deficits will exceed 10 percent of GDP if we have a mild economic downturn or get drawn into a hot war.
The Congressional Budget Office estimates that, by mid-century, interest payments on our mountains of debt will eat up 35 percent of tax revenues. But those estimates rely on interest rates near 4 percent. If interest rates stay near 5 percent, we would need closer to 50 percent of tax revenues to pay for old and new debts, leaving less revenue available for government functions like defense.
The bond market sees the long-term fiscal problems, but as the world’s reserve currency, the U.S. has ample access to liquidity. Instead, what set the bond market off has been an avalanche of debt issuance in the third and fourth quarters.
In the months before the debt limit was lifted via the Fiscal Responsibility Act of 2023, debt issuance was on pause while Treasury was unable to borrow more than the statutory limit. While issuance was on pause, the accumulating deficit and inability to borrow created a pent up need to tap markets for funds when the debt limit was lifted. When it resumed issuance, Treasury had to borrow not only for normal government operations, but also to refill all the government’s savings accounts it had drained to avoid default, a result of the debt-limit standoff.
Then, in early August, Treasury announced it was going to begin rolling the bills it had issued into longer term bonds, meaning that there would be an increase in the number of bonds made available to the market.
As we know, prices are a function of supply and demand, and Treasury announced a supply bonanza. The natural economic response was to push prices down. Since yields and prices move in opposite directions, yields started moving higher.
In other words, the term-premium investors’ demand to hold Treasury debt — over and above their expectations of where Federal Reserve policy will be in the future — increased dramatically. Moreover, the increase has all occurred in the real, or after-inflation component of the yield, and not in the part of the yield designed to compensate investors for expected inflation. The implication is that investors are requiring a substantial incentive on Treasury bonds to accept the additional supply.
The other possible explanations for higher yields are less likely. If Fed policy were insufficiently loose, investors’ expectations of inflation in the future would be materially higher, and the increase would have shown up more in the inflation component than the real yield. Higher real yields might reflect stronger long-term potential growth for the economy, but a doubling in recent months? One would have to believe large language models or some other innovation is on the verge of doubling potential growth, which at this point strains credibility.
When will the rout stop? Bonds are now approaching decent value. But the problem is the main seller of bonds, the Treasury Department, isn’t selling because it thinks bonds are overpriced and a bad investment. Treasury is a price-insensitive seller because Congress made it so. Thus fundamentals may have a hard time reasserting themselves, and cheap assets can become cheaper.
Of course, the higher real yields on bonds have significant implications for all other assets. If investors can get 2.5 percent real yields, they are likely to demand higher risk premia on equities as well, which may push stock prices lower. If that happens, a weaker economy is likely to induce additional demand for Treasury, which may help stabilize prices.
In the meantime, investors are looking ahead to the next Treasury issuance announcement, due November 1, as they wait to see how big the next mountain of supply dropped on the bond market will be.