US Federal Reserve action to raise short-term rates to choke inflation can’t explain this post-summer yield spike. Inflation has fallen more swiftly than in other countries and the Fed has telegraphed that it’s pretty much done with tightening. No, growing budget deficits coupled with an increased supply of Treasury debt are the likely culprits. Some recent debt auctions simply have seen investors less keen on America’s long-duration bonds.
Owing to the combination of higher borrowing costs and new borrowing, forecasts suggest that the US budget deficit will hit 7.7 per cent of GDP this year, a peak not reached outside of wartime or national emergencies since the 1930s. This could well be an underestimate. Open-ended tax subsidies through the Inflation Reduction Act, for example, create meaningful uncertainty over the scale of borrowing and so the path of interest rates.
The rising borrowing costs risk a fiscal doom loop, too. The average duration of outstanding US debt, at 75 months, is much shorter than that of the UK. According to the Committee for a Responsible Federal Budget, an American think tank, half of all outstanding federal government debt must be refinanced within the next three years, at higher interest rates than previously envisaged. The higher rates go up or the longer they endure, the more rising government borrowing costs will drive higher deficits, driving yields higher still.
To avoid that spiral, countries typically self-impose deficit rules or targets. The UK government, for example, says it plans to eliminate borrowing net of interest payments by 2026–27. Yet present US policy is on course to run equivalent primary deficits (net of interest payments) of 3 per cent of GDP across a decade. Even this is predicated on the heroic assumption that no new spending programmes will be introduced after a presidential election and that most of Donald Trump’s tax cuts will be allowed to expire.
Right now, most economic models simply crash if you assume unchanged policies and use them to project America’s fiscal and economic future. To avoid forecasting catastrophe, modellers have to assume that politicians eventually will slash spending or raise taxes to avoid an explicit default or an implicit one (where the Fed prints a tonne of money and buys up US government debt).
Might markets soon start reassessing that assumption? Today, despite rising yields, there’s no meaningful talk in Washington of any near-term deficit reduction efforts, let alone bipartisan talks to reform the country’s unsustainable old-age social security and Medicare programmes. Washington still regularly engages in stand-offs over whether to keep the government open and its hardly inspiring governance that the House of Representatives took ages to select a Speaker. Given how much fiscal news dominates British politics, this may be hard to believe, but this debt issue hasn’t really featured in presidential election debates so far. Presidents Biden and Trump, the probable candidates in 2024, each presided over substantial debt increases in government, while both still pledge to protect the entitlement programmes that will escalate debt in future.
Modellers at Penn-Wharton calculate that the US already has only two decades to consolidate its finances to stave off some form of default, beyond which no spending cuts or tax rises can avoid it. And that’s assuming no other big shocks hit the economy. In other words: America may be only a couple of wrong steps or unfortunate events away from a full-blown debt crisis.
It’s true, as Paul Krugman, the Nobel prizewinner, regularly points out, that markets are not signalling such an acute “fiscal crisis” yet. Yields on treasuries and bonds are elevated but are not continually surging. Inflation expectations remain anchored and the dollar is strengthening. These data points hardly scream that investors fear default or the imminent prospect of the Fed having to monetise debt. Yet history shows that fiscal crises come slowly and then quickly. Greece was able to borrow relatively cheaply, until it wasn’t. There the trigger was a realisation that the previous government had cooked the books, with the actual deficit being much higher than state records implied.
The shift from a high to low confidence regime can be brutal. If the United States faced some unexpected shock, such as another large recession or a war or had to borrow $10 trillion to bail everyone out again, would investors remain sanguine today? In the recent past, economic commentators comforted themselves that America’s reserve currency and safe haven status meant its capacity for borrowing was near-limitless. In today’s febrile environment, that looks like a risky bet.
