Governments rarely correct their deteriorating public finances before encountering some form of disruption in the debt market, but the withdrawal of central banks from sovereign bond markets could ultimately pave the way for a showdown.
Market anxiety over the spectacular accumulation of debt by Western governments since the pandemic – some would even say since the global financial crisis 16 years ago – has not yet been followed by action or warning shot from investors.
Although bond prices have been predictably hit by soaring global inflation and interest rate hikes over the past three years, they have so far been revalued by relatively orderly manner, in line with the new official rate parameters.
Aside from the brief shock in UK gilts after the UK budget blowout in 2022, there have been few signs of stress in the US or Eurozone debt market, and risk premia for holding debt at longer term remain historically low.
Assuming the inflation and rate storm is finally over, markets have not demanded much additional compensation for financing ever-larger deficits and national debts.
Yet lamenting the lack of corrective action on spending and bloated budgets in a year marked by multiple elections – particularly in the United States, where the government bond market is the largest in the world – , the International Monetary Fund issued a warning again last month: “Concessions will have to be made.”
If the IMF pointed the finger at most developed and emerging economies, it was especially concerned about an American budgetary position “not consistent with long-term budgetary sustainability”, in particular because of the central position of the bond market government, now worth $27 trillion, as a benchmark for global borrowing costs.
The raw numbers are well documented. In March, the Congressional Budget Office projected that the U.S. government debt would reach a record 107% of national output by the end of the decade and more than 150% in 20 years, based on current budget trajectories. and interest costs.
And yet, with sales of new sovereign debt already running into the hundreds of billions each quarter, the relative calm of the bond market to date 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 a 16-year average that covers the expansion of the Fed’s balance sheet in bond purchases.
Even as they fade, hopes the Fed will cut interest rates this year have partly helped support bonds, even as the Fed continues to deplete the vast reserve of Treasuries it recorded on its balance sheet during the pandemic.
Although slowing the pace of “quantitative tightening” may be discussed at this week’s Fed policy meeting, there is little sign of it stopping – much less a resumption of purchases.
And it’s not the only reliable buyer who is quietly withdrawing.
SURFING THE “TSUNAMI
Barclays’ annual Equity Gilt Study, released this week, dissected the market’s treatment of what it called the “Treasury tsunami” of new debt supply.
She concludes that as the Fed and other global central banks gradually withdraw from bond markets, investors will begin to assess the flood of debt more cautiously.
In-depth analysis of U.S. debt dynamics and pricing in the Treasury market has cast doubt on some of the most frightening reports about a “sudden stop” in demand for such an important global asset, even a dramatic decline in the reserve status of the dollar.
But he said the 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 central banks foreign countries, will likely lead to greater market adjustment in the future.
The buyer base of U.S. Treasuries has slowly shifted from price-insensitive investors, such as foreign central banks, who “need” to buy government bonds, to those who are price-sensitive, such as the domestic household sector, which “chooses” to purchase them,” the agency said, adding that hedge funds were also included in this “household sector.”
“This transition is expected to raise term premiums to levels more consistent with fundamental factors, which would themselves be subject to new pressures.
An exceptional environment of “higher for longer” US rates, driven by continued US deficit stimulus, now risks keeping the dollar higher around the world and could force many developing countries to cut their dollar reserves and their holdings of Treasury securities to support their local currencies.
The central banks of emerging countries are not the only ones concerned: we also find this scenario in the battle that Japan is waging this week to support the yen, which has fallen to its lowest level in 34 years.
Additionally, future years of increased spending or extended tax cuts – or both – will serve to raise the Fed’s “neutral” policy rate assumption over time relative to the current view of 2, 6% from the Fed itself.
With the market now estimating that inflation will run above target at around 2.5% in the long term, Barclays estimates that the long-term neutral policy rate could rise as high as 4%.
The study adds that “worsening fiscal dynamics” also increases the volatility of Treasury bonds, which feeds back into the market in several ways, including undermining the portfolio diversification argument of holding bonds. bonds to offset tensions on the stock market.
In addition, the maintenance of key rates and interest rates at high levels, above 5%, calls into question private demand for 10-year government bonds, the rate of which is still below 4.6 %.
The result ?
A higher term premium, the assumption of a neutral policy rate, and volatility risk push long-term borrowing rates higher and invert the Treasury yield curve, regardless of whether the Fed sharply reduces its rate or not.
And if investors struggle to absorb the scale of the new debt without a change in fiscal stance, Barclays fears problems could arise.
“The Treasury universe has become too large and investors need to consider the potential for increased episodes of illiquidity, malfunctioning and increased volatility when thinking about valuations.”
It remains to be seen whether this disruption will be enough to force Washington to change its mind after the election.
The opinions expressed here are those of the author, a columnist for Reuters.
