The US interest bill soared last month to kick off the fiscal year and prospects are it is going to keep on climbing. The Treasuries market keeps on growing and topped $26 trillion, up more than $10 trillion in the space of five years.
Breaching the 5% barrier in October for the first time since 2007 served as an indication of how tight financial conditions have become in the Fed’s rate-raising cycle, foreshadowing the growing squeeze ahead for the US economy. The 10-year Treasury yield has risen more than 3% in the past two years. The high volatility and speed of the sell-off in recent weeks, at a time when liquidity in Treasury markets “remained challenged”, according to a US Federal Reserve (Fed) report last week, is concerning.
There are of course many drivers behind the recent jump in 10-year yields. Investors have now accepted the Fed’s “higher for longer” narrative on rates, particularly as strong economic data has backed up its rhetoric. Second, the “term premium”, or the additional yield investors need to compensate for holding long-term bonds, has probably risen.
And then there are supply and demand dynamics at work: the US government’s widening deficit has driven higher bond issuance, while rising spending needs and political turmoil are raising expectations for future Treasury supply too. But demand has fallen, particularly with the Fed shrinking its Treasury holdings via quantitative tightening, and geopolitical competitors holding off purchases. This is pushing up yields, but uncertainty also remains high. While 10-year yields have been on an upward march since the Fed began raising rates, intraday swings are common.
Elevated yields will exacerbate fiscal concerns, with spending on interest payments rising. Mortgages and corporate bonds, which are linked to long-term Treasury yields, have become costlier. Stock valuations could be further strained. Together, this raises the chance of a deeper and longer economic slowdown, which could pull down yields. Indeed, market skittishness poses its own risks, particularly when Treasury liquidity remains below historic norms. Investors looking to lock in high yields may be reticent to buy if they think prices could fall further. The risk of sharp yield movements could also threaten institutions holding large bond losses, and stoke distressed Treasury sales.
The volatility is an inevitable consequence of investors trying to price Treasuries amid heightened uncertainty and following years of the Fed’s bond-buying. The lack of clarity on the economic outlook means a convincing ceiling for yields is also far off.
Above all, the US needs to display fiscal prudence. The deficit as a share of gross domestic product is projected to balloon. Higher debt issuance in a market short of buyers will keep upward pressure on yields. Paralysis in the US Congress does not help. High rates, allied with lax fiscal policy and political chaos, are a recipe for a vicious cycle of rising government yields.
Ever higher interest bills add to the difficulties created, boosting the potential for further spikes in Treasury yields and volatility. And that is before one even considers the ongoing dysfunction in Congress that is threatening yet another federal shutdown.
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