The Bond Markets Are Sending a Warning to Washington
Story by Desmond Lachman, Barron’s, 10/19/23
About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
James Carville, President Clinton’s political adviser, once observed that he would like to be reincarnated as the bond market. “You can intimidate everyone,” he quipped.
The 10-year Treasury bond yield has spiked dramatically over the past three months from around 4% to almost 5%. That is its highest level since 2007. As the bell-weather for world financial markets, it has caused a generalized spike in world long-term interest rates.
The recent dramatic return of the bond vigilantes should be a wake-up call for Washington about the need for serious budget reform. Without it, the country could be well on its way to another financial market crisis and to fiscal ruin.
Markets have suddenly woken up to the sorry state of the country’s public finances. In particular, they are now focusing on the fact that the U.S. budget deficit is 8% of gross domestic product at a time of full employment and when the public debt is already at around its second World-War high. Worse, there is every prospect that the budget deficit will widen in the event of an economic recession and continued high interest rates. With current budget policies, there is little prospect that the public debt will stop increasing at its recent explosive rate.
Markets have wised up to the idea that the government will have difficulty funding its unusually large budget deficits over the next few years. Traditional foreign buyers of U.S. Treasury bonds, including the Chinese and Japanese central banks, seem to have lost their appetite for those bonds. They have done so because of Washington’s profligate ways and its increased resort to economic sanctions. Meanwhile, the Federal Reserve, which used to be a large buyer of U.S. Treasuries under its earlier quantitative easing policy, is now a big seller under its quantitative tightening program. That program is an important part of its effort to regain inflation control.
Even before the recent surge in long-term government borrowing rates, the Congressional Budget Office forecast that by 2029 the federal debt held by the public, measured in relation to GDP, would reach 107%. That would surpass its highest level in history. Higher interest payments will only add to our budget deficit problems and put our public debt on an even more unsustainable path.
By 2050 spending on interest will be the single largest line item in the federal budget, according to the Committee for a Responsible Budget. It will surpass Social Security, Medicare, Medicaid, and all other mandatory and discretionary spending programs.
The risks of spiking Treasury bond yields are not limited to the U.S. The chances of a world financial market crisis are also troublingly high. World debt levels are at record highs, and much of that debt was contracted at very low interest rates. This has to raise serious questions as to how borrowers in general will manage to roll over their debt at markedly higher interest rates than that at which the debt was originally contracted. This will be a particular problem for real commercial property developers that have $500 billion in debt maturing next year, when occupancy rates are unlikely to have recovered from the pandemic.
A record slump in bond prices contributed to the failure of First Republic Bank and Silicon Valley Bank earlier this year. Those were the second and third largest U.S. bank failures on record. The 10-year Treasury yield was 3.7% when Silicon Valley Bank failed in March. It has since risen by well over a percentage point. That must now be expected to cause a further significant dent in banks’ balance sheets. That could be especially problematic for regional banks, which have an unusually high exposure to troubled commercial real estate loans.
Economist Herb Stein famously said that if something cannot go on forever it will stop. This is certainly true of our unsustainable public finances. It would also seem to be true of our financial system, which is now being seriously challenged by slumping bond prices and could be hit by a wave of defaults next year.
In principle, if Congress were to get serious about budget reform, it could relieve the current pressure on the Federal Reserve to keep interest rates high to contain inflation. That would both help put our public finances on a sounder footing and reduce the chances of a full-blown financial crisis. However, judging by Washington’s current political dysfunction, holding your breath while you wait for a fix might not be wise.