The US Federal Reserve (Fed) in late September slashed its short-term rate target by 50 basis points (bps) and signalled more cuts are to come. Yet in that time, investors have pushed the yield on the 10-year Treasury note from 3.65% to 4.1%, the highest in two months.
US Treasury Bonds over 1 month to 15 Oct 2024
Source: Trading Economics
Why would long rates rise while the Fed’s rates fall? The Fed sets interest rates for the immediate future. Investors are betting on the path of those rates for the next decade. And for two reasons, interest rates are likely to be higher in the coming decade than in the prior one.
One of those reasons is relatively benign; inflation and growth won’t be as low as before the pandemic. The second reason is more worrying. The US federal debt is on an unsustainable path, which might become even more unsustainable after the election, especially if Donald Trump wins and Republicans take control of Congress.
More than a year ago, the Fed pushed its rate target to a 20-year high of 5.5% to make sure inflation didn’t stay stuck above its 2% target, even if that meant causing a recession. By September, inflation was coming back to 2%. The half-point cut signalled that the Fed’s priority was now protecting the labour market and ensuring unemployment did not spike. It hasn’t yet.
Source: Wall Street Journal
Indeed, rather than a spike in unemployment, the market was dealt a new hand. The September jobs report changed the picture of the labour market. Far from being in deterioration, it was in robust health. The US jobs data drastically reduced investors’ expectations of a recession that would force the central bank to slash rates deeply in the next year. The soft landing had arrived. That alone would merit higher long-term rates.
Meanwhile, it is possible economic growth will surprise with a robust 2.8% pace over the past four quarters. That would suggest that the US economy has become less vulnerable to higher interest rates. Using the jargon employed by economists, the “neutral rate,” which keeps inflation and unemployment stable and balanced, has apparently risen. As recently as December, Fed officials thought neutral was 2.5%. By September, they had raised that to 2.9%, and some officials had put it at 3.5% or higher.
By itself, a higher neutral is nothing to worry about (though maybe not if you’re trying to get a mortgage) because it signals a return to normalcy. Ever since the GFC, we’ve wanted to get “back to normal” – so what’s there to complain about?
Well, there are increasing risks out there that cannot be ignored – one of which is the soaring federal debt. Since 2007, the US federal debt has climbed from 35% of gross domestic product to 98%. Much of this was a result of the 2008-09 financial crisis and Covid-19. The borrowing didn’t put much upward pressure on bond yields because inflation and the neutral rate were so low. Low rates, in turn, made the debt relatively easy to support.
Yet in the past fiscal year, Washington borrowed $1.8 trillion. At 6.4% of GDP, that’s a record outside of war, recession, or crises such as the pandemic. Interest expense is climbing steadily. The Congressional Budget Office projects that under current law, publicly held debt will hit 122% of GDP in 2034.
The effect on long-term rates has been largely invisible thus far. It might become more visible before long – largely in the form of the rising US Treasury yield.
Both Kamala Harris and Donald Trump have proposed lavish spending and tax cuts that would add significantly to the debt. With the election on a knife-edge, there are few hopes either candidate will be restrained in their promises – there is simply too much at stake.
The non-partisan Committee for a Responsible Federal Budget (CRFB) has added up all their promises and its baseline estimate of the debt impact: $3.5 trillion for Harris, and $7.5 trillion for Trump from 2026 through 2035.
Source: Wall Street Journal
“Neither has anything close to a plan to deal with the overall debt, but clearly the Trump agenda would be significantly worse than the Harris agenda,” said Maya MacGuineas, president of the CRFB.
There are wide uncertainty bands around both estimates. Trump regularly drops new proposals with little detail or explanation of how they will be paid for. Yet it would be a mistake to dismiss Trump’s plans as unserious. They not only are more costly than Harris’s, but they also are more likely to be enacted.
Certainly, Joe Biden had no compunction about running up debt for his spending priorities. Still, if Harris became president, Republicans are strongly favoured to take back control of the Senate, where they would likely block most of her costly spending plans, whereas the party that wins the White House would probably also win control of the House of Representatives.
In any event, no investors (whether in Treasury markets or the stock market) want to see a “Liz Truss moment” in US financial markets – if that occurs, the 2-year-old bull market might just become another tombstone announcement in the history books.