In our most recent Weekly Update, we touched upon how Moody’s decision to downgrade US sovereign debt had caused a stir, yet we argued that its impact would be minimal, considering the downgrade did not present substantially new information. This observation triggered a broader discussion amongst us, leading to this article, where we aim to dissect and analyse factors influencing the US Treasury market, particularly the long-end segment, distinguishing between what is consequential and what is not.
Contrary to widespread concerns, the phenomenon dubbed as the “debt wall” holds minimal importance in the grand scheme. Visual representations of US government debt scheduled for refinancing, be it on a monthly or quarterly basis, depict a formidable “wall” needing attention within the next 12 months. This pattern, where 25%-35% of the total debt falls under T-Bills (short-term debt securities maturing within a year), has remained relatively consistent over the past decade and is expected to continue as such in the foreseeable future. It’s also worth noting that a significant portion of T-Bill investors routinely roll over their investments upon maturity, alleviating the pressure on the US government to continuously scout for new creditors.
Furthermore, the notion that the Federal Reserve’s prolonged tight monetary policy stance might adversely affect the longer end of the Treasury market is misplaced. In reality, such a stance could mitigate inflation risks—both actual and perceived—thereby potentially contributing positively amidst prevailing inflationary concerns sparked by recent events.
The prospect of large-scale divestment in Treasury securities by foreign governments, often cited as a potential threat, also lacks substantial grounding. Generally, foreign governments, through their central banks, engage in buying or selling US government debt as a means to manipulate their own currency exchange rates, selling when the US dollar strengthens to support their local currency, and buying when it weakens to prevent their currency from overshooting. The ongoing trade disagreements initiated by the US do not necessarily undermine this dynamic of foreign exchange reserve management.
Shifting focus to factors that do indeed merit attention, the fiscal deficit stands out as a primary concern for long-dated Treasury holders. A significant fiscal deficit not only increases the supply of government debt securities but also potentially fuels inflation by diverting savings from the more efficient private sector to the less efficient public sector. Especially concerning is a fiscal scenario where the deficit grows both in absolute terms and as a percentage of the economy.
Analysing trends outside of the COVID-19 anomaly years of 2020 and 2021, it becomes evident that the US federal deficit is on an upward trajectory relative to nominal GDP. This trend is expected to persist, particularly with the current legislative proposition in the US parliament that proposes immediate tax reductions while deferring spending cuts. This fiscal strategy heralds probable declines in Treasury bond prices and an uptick in yields in the coming years.
Another factor that could exert upward pressure on bond yields is the inflationary impact of tariffs. The trade measures championed by former President Donald Trump might introduce a temporary inflation spike, but the longer-term consequence is a potential dilution of the dollar’s purchasing power through reduced economic efficiency, thereby making a case for higher bond yields.
A final point of concern, though not immediately pressing, relates to the likelihood of Federal Reserve interventions in response to recession indicators. Such interventions often involve substantial money supply injections, a move that could coincide with a rapidly widening government deficit, exacerbated by falling tax revenues and escalating government support expenses. This scenario could ignite an inflationary surge.
In summary, while some of the frequently highlighted bearish indicators for US Treasury Bonds lack substance, there are indeed legitimate reasons for concern. The political landscape, showing little inclination towards reining in deficit spending or capping its growth, leaves bond market dynamics to impose necessary adjustments through increased yields. This outlook necessitates a nuanced understanding of market drivers, distinguishing between mere noise and genuinely impactful developments.
