Governments rarely correct deteriorating public finances until they meet some form of debt market disturbance, but the retreat of central banks from sovereign bond markets may eventually set the scene for a showdown.
Longstanding market angst about the dramatic buildup of Western government debt since the pandemic - some might say since the global financial crisis 16 years ago - has not yet been matched by anything approaching an investor strike or warning shot.
Even though bond prices were predictably hammered by the global inflation spike and interest rate rises over the past three years, they have so far re-priced in a relatively orderly manner in keeping with the new official rate parameters.
Aside from the brief British gilt shock after 2022′s quickly-reversed UK budget blowout, there’s been little sign of market stress in U.S. or euro zone debt, and risk premiums for holding longer duration debt remains historically subdued.
Perhaps assuming the inflation and rate storm is finally over, markets have not demanded much additional compensation for funding ever larger deficits and national debt burdens.
Yet bemoaning a lack of remedial action on bloated spending and budgets in a year of multiple elections - particularly in the United States with the biggest government bond market in the world - the International Monetary Fund warned again last month: “Something will have to give.”
While the IMF wagged its finger at most developed and emerging economies, it reserved most concern for a U.S. fiscal stance “out of line with long-term fiscal sustainability” - not least given the now $27 trillion Treasury market’s pivotal position as a benchmark for global borrowing costs.
The raw numbers are well documented. The Congressional Budget Office in March forecast U.S. government debt would rise to a record 107% of national output by the end of the decade and north of 150% in 20 years under current budget and interest cost trajectories.
And yet, already facing hundreds of billions of new sovereign debt sales every quarter, the bond market’s relative calm to date is remarkable.
After all, the New York Federal Reserve’s estimate of the 10-year “term premium” demanded by investors for holding longer-maturity Treasuries remains close to zero - some 150 basis points below the 60-year average and 35 bps below a 16-year mean that covers the Fed’s bond-buying balance sheet expansion.
Albeit faded, hopes for Fed interest rate cuts this year have been partly responsible for supporting bonds - even while the Fed continues to run down the vast stash of Treasuries loaded onto its balance sheet during the pandemic.
While slowing the pace of “quantitative tightening” may well be discussed at this week’s Fed policy meeting, there’s little sign of it ending - let alone any resumption of buying.
And it’s not the only reliable buyer quietly stepping away.
SURFING THE ‘TSUNAMI’
Barclays’ annual Equity Gilt Study published this week dissected the market treatment of what it dubbed the “Treasury tsunami” of new debt supply.
It concluded that as the Fed and other global central banks gradually back away from bond markets, investors will now start to price the debt flood more cautiously.
The deep dive into the runes of U.S. debt dynamics and Treasury market pricing doubted some of scarier stories of a “sudden stop” in demand for such a critical world asset or even a dramatic decline in the dollar’s reserve status.
But it said a combination of unchecked ballooning deficits buoying growth with high and volatile interest rates and inflation as well as a reduction in “price insensitive” bond holders such as the Fed and foreign central banks will likely seed a bigger market adjustment ahead.
“The buyer base of U.S. Treasuries has slowly been shifting away from price-insensitive investors, such as foreign central banks, which ‘need’ to buy government bonds, to price-sensitive ones, such as the domestic household sector, which ‘chooses’ to buy them,” it said, adding hedge funds were also bucketed in that “household sector”.
“This transition should raise term premia to levels that are more consistent with fundamental drivers, which themselves would be under further pressure.”
An exceptional “higher for longer” U.S. rate environment spurred by persistent U.S. deficit-related stimulus now risks keeping the dollar buoyed around the world and may see many developing countries forced to run down dollar reserves and related Treasury holdings in support of local currencies.
And it’s not just emerging market central banks - there’s something of that scenario too in Japan’s unfolding battle this week to prop the yen from 34-year lows.
What’s more, years to come of higher spending or extended tax cuts - or both - will serve to lift the “neutral” Fed policy rate assumption over time from the Fed’s own current 2.6% view.
With market pricing now seeing inflation settling above target at about 2.5% longer term, Barclays reckons the long-term neutral policy rate could be as high as 4%.
The study goes further say “worsening fiscal dynamics” are also lifting Treasury volatility, which feeds back into the market in a number of ways - not least undermining the portfolio diversification argument for holding bonds as an offset for any stock market stress.
And keeping policy and cash rates high at current levels above 5% also challenges private demand for 10-year Treasuries still lower around 4.6%.
The upshot?
A higher term premium, neutral policy rate assumption and volatility risk pushing long-term borrowing rates higher and flipping the Treasury yield curve positive, whether the Fed cuts rates sharply or not.
And if investors struggle to absorb the scale of new debt without a change of fiscal tack, Barclays fears there may be trouble ahead.
“The Treasury universe has grown too large and investors need to factor the potential for increased bouts of illiquidity, poor functioning, and heightened volatility when thinking about valuations.”
Whether it’s enough of a disturbance to force a change of thinking in Washington after the election remains to be seen.
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