The world’s safest asset has gone rogue.
U.S. Treasuries, regarded as the bedrock of the global financial system, are serving up the kind of daily price swings one would expect from the average stock. On a slightly lesser scale, Canadian government bond prices have followed suit.
Long-term yields on both sides of the border had huge downward moves last week, first after the U.S. Federal Reserve held the line on policy rates, then as U.S. employment figures for October showed a slight cooling off of the red-hot jobs market.
Last month it was a different story, with 10-year yields spiking to their highest levels in more than 15 years.
This volatility in government paper has outlasted the worst of the inflation eruption, as well as the jumbo-sized rate hikes that ensued.
Why then are securities renowned for their stability still so unstable? Strained government finances are emerging as a prime culprit.
“Fiscal sustainability and the related bond supply this entails remains problematic,” Taylor Schleich, director of economics and strategy at National Bank Financial, wrote in a note published on Wednesday.
“To put it simply, the U.S. is still borrowing far more than it ‘should’ be, particularly given the strength of the economy.”
Over the past few months, U.S. fiscal tensions have increasingly come into view.
In late July, the U.S. Treasury Department announced that it would need to borrow more than US$1-trillion in the third quarter alone, which was far more than the market was expecting. Further increases to quarterly bond auctions would probably be necessary, it said.
All of the unanticipated bond issuance added further pressure to bond prices, which were already coming off a horrendous year in 2022.
So much value has now been lost in long-duration U.S. Treasuries that this sell-off ranks as the worst in history, by some measures.
And by all indications, the borrowing requirements of the U.S. government will remain astronomical. The latest estimates for the U.S. budget deficit in fiscal 2023 peg the shortfall at US$2-trillion after removing a student loan forgiveness plan.
In the days after those figures were released a few weeks ago, the yield on U.S. 10-year government bonds rose above 5 per cent for the first time since 2007. That benchmark yield has since dipped to 4.5 per cent.
Governments these days are caught in a negative feedback loop, forced to borrow at higher and higher interest rates.
The cost to service the U.S. federal debt is the fastest-growing part of the government’s budget. Net interest costs hit US$659-billion in the 2023 fiscal year, up nearly 40 per cent from the previous year.
Soaring interest payments put pressure on budgets, necessitating more borrowing, which pushes up bond yields and adds further to debt-servicing costs.
“It is a vicious circle,” said Ian Pollick, head of fixed income, currency and commodities strategy at Canadian Imperial Bank of Commerce. “The cost to service all this debt is a very big force that is pushing deficits into worse positions.”
The same dynamic is at play in Canada. The federal government is expected to spend $46.4-billion on interest payments this fiscal year, according to projections released by the Parliamentary Budget Officer last month. That’s up from $24.5-billion two years ago.
Meanwhile, auction sizes have been creeping up for Canadian bonds of 10 years or less, and it’s likely that trend will soon shift to longer durations as well, Mr. Pollick said. “We’re starting to see the very early signs of a mini-supply shock in Canada.”
But the U.S. is in far worse shape, both in terms of the size of its debt, and in how that debt is being managed.
At the same time as the U.S. Treasury is flooding the market with new supply, a key buyer of those bonds has essentially left the market.
Since the pandemic started, the U.S. has added roughly US$10-trillion to its debt load. And for the first couple of years after COVID-19 hit, most of that bond issuance was hoovered up by the Fed.
In order to inject money into the financial system through the worst of the crisis, the Fed bought up colossal amounts of Treasury bonds and mortgage-backed securities, more than doubling its balance sheet to nearly US$9-trillion.
That stimulus machine has since gone into reverse, as part of the measures taken to rein in inflation and slow down the economy. The Fed is reducing its stockpile of government securities at a pace of up to US$95-billion a month.
With the Fed out of the bond-buying game, there are legitimate concerns about who will buy up all of the bonds the U.S. government is issuing.
An auction of 30-year U.S. Treasuries in October appeared to underline weakening demand. Dealers were forced to scoop up nearly one-fifth of the US$20-billion issuance, after investor interest proved limited.
“Demand for U.S. Treasuries may have softened among several traditional buyers,” the Treasury Borrowing Advisory Committee wrote in a report to Treasury Secretary Janet Yellen last week. “Investors may now require an additional yield … to hold longer-term debt.”
Tim Shufelt