Governments rarely correct deteriorating public finances until they face some form of debt market disruption, but the withdrawal of central banks from sovereign bond markets could eventually pave the way for a confrontation.
Markets’ long-standing angst over Western governments’ spectacular accumulation of debt since the pandemic – some might say since the global financial crisis 16 years ago – has yet to be offset by anything whether it resembles an investor strike or a warning shot.
Although bond prices have been predictably hit by soaring global inflation and rising interest rates over the past three years, they have so far been revalued significantly. relatively orderly, in line with the new official rate parameters.
Aside from the brief shock in UK government securities following the rapidly reversed UK fiscal blowout in 2022, there have been few signs of stress in US or eurozone debt markets, and risk premiums for the Longer-term debt holdings remain historically moderate.
Perhaps assuming the inflation and rate storm is finally over, markets have not demanded much additional compensation to finance ever-larger deficits and the national debt burden.
Yet lamenting the lack of corrective action on bloated spending and budgets in a year marked by multiple elections – particularly in the United States where the world’s largest government bond market is located – The International Monetary Fund warned again last month: “Something will have to give.” »
While the IMF pointed the finger at most developed and emerging economies, it was most concerned about a US fiscal stance “not consistent with long-term fiscal sustainability” – particularly given the central position of the Treasury market, today estimated at $27 trillion, as a benchmark for global markets. borrowing costs.
The raw numbers are well documented. In March, the Congressional Budget Office projected that the U.S. public debt would reach a record high of 107% of national output by the end of the decade and more than 150% in 20 years, given current budget and debt trajectories. interest costs.
And yet, already facing hundreds of billions in new sovereign debt sales every quarter, the relative calm of the bond market so far is remarkable.
After all, the New York Federal Reserve’s estimate of the 10-year “term premium” required by investors to hold longer-dated Treasuries remains close to zero – some 150 basis points below the 60-year average and 35 basis points below the 16-year average. That means it covers the expansion of the Fed’s bond-buying balance sheet.
Although they have faded, hopes of lower interest rates from the Fed this year have been partly responsible for supporting bonds – even as the Fed continues to deplete the vast reserve of Treasuries loaded into its assessment during the pandemic.
Although slowing the pace of “quantitative tightening” may well be discussed at this week’s Fed policy meeting, there is little sign of an end to this process – much less a resumption of purchases .
And it’s not the only reliable buyer who is quietly moving away.
SURFING THE ‘TSUNAMI’
Barclays’ annual Equity Gilt study released this week analyzed the market’s treatment of what it dubbed the “Treasury tsunami” of new debt offerings.
He concludes that as the Fed and other global central banks gradually withdraw from bond markets, investors will now begin to assess the debt flood more cautiously.
In-depth analysis of the dynamics of U.S. debt and Treasury market prices has cast doubt on some of the scariest stories of a “sudden stop” in demand for such a crucial global asset or even a dramatic decline in the reserve status of the dollar.
But he said a combination of unchecked growing deficits, supporting growth with high and volatile interest rates and inflation, plus a reduction in “price-insensitive” bondholders such as the Fed and the foreign central banks, would likely result in a larger market adjustment going forward.
“The buyer base of U.S. Treasuries has gradually shifted away from price-insensitive investors, such as foreign central banks, who ‘must’ buy government bonds, to price-sensitive investors, such as domestic household sector, who “select” to buy them,” he said, adding that hedge funds were also grouped in this “household sector.”
“This transition should bring term premiums to levels more consistent with fundamental factors, which would themselves be subject to new pressures. »
An exceptional environment of “higher and longer” US rates, boosted by persistent US deficit-related stimulus, now risks keeping the dollar supported around the world and could see many developing countries forced to dip into their dollar reserves and associated Treasury holdings to support local currencies.
And it’s not just emerging market central banks: there’s also a similar story in Japan’s battle this week to prop up the yen from a 34-year low.
Moreover, the coming years of higher spending or broad tax cuts – or both – will serve to move away over time from the Fed’s “neutral” policy rate assumption, which it forecasts. -even at 2.6%.
With market prices now seeing inflation running above target at around 2.5% in the long term, Barclays estimates that the long-term neutral policy rate could reach 4%.
The study goes further to argue that “worsening fiscal dynamics” also increases Treasury volatility, which feeds back into the market in several ways – notably undermining the portfolio diversification argument in favor of holding bonds to offset any stock market tension.
And keeping policy and cash rates at current levels above 5% also challenges private demand for 10-year Treasuries, still below around 4.6%.
The result ?
A higher term premium, neutral policy rate assumption, and volatility risk push long-term borrowing rates higher and make the Treasury yield curve positive, whether or not the Fed cuts rates sharply.
And if investors struggle to absorb the scale of the new debt without a change in fiscal policy, Barclays fears problems could arise.
“The Treasury universe has become too large and investors need to consider the potential for increased episodes of illiquidity, poor performance and increased volatility when thinking about valuations.”
It remains to be seen whether these disruptions will be enough to force a change in thinking in Washington after the election.
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