Rising Treasury Yields Spark Financial Concerns
The recent climb in the 10-year Treasury yield to 5% has triggered significant anxiety about the financial health of the United States. Initially, these fears seemed exaggerated, especially since the Federal Reserve had paused its interest rate increases, giving the markets some breathing room and allowing the S&P 500 to maintain its upward momentum. Nevertheless, the looming possibility of a debt crisis remains a serious concern that could disrupt both the financial and stock markets.
The Federal Reserve’s historical policies, which have accommodated large budget deficits and led to the highest inflation rates in 40 years, now seem to be straining government finances. Pressure on the Treasury market is expected to grow. The Fed’s approach of keeping interest rates low has encouraged fiscal policies that have significantly increased the national debt by $20 trillion since the 2008 financial crisis.
The Fed’s Influence on Debt Growth
The increasing deficit for the government’s 2023 fiscal year, which ended on September 30, underscores the deteriorating state of federal finances. Despite robust GDP growth, poverty levels are nearing historic highs, exacerbated by the Supreme Court’s rejection of President Biden’s student loan forgiveness plan, effectively doubling the deficit to $2 trillion. The Federal Reserve’s halt in bond interest transfers to the Treasury last year due to falling bond prices resulted in a loss of over $100 billion in revenue, further worsening the financial outlook.
Companies heavily invested in Treasuries, like Silicon Valley Bank, faced insolvency as Treasury yields rose, necessitating an additional $100 billion in Federal Deposit Insurance Corporation (FDIC) loans. Additionally, the federal government had to pay an extra $177 billion in interest on its debt following the Fed’s rate hikes, a trend expected to continue.
Escalating Debt Servicing Costs
The cost of servicing the national debt has surged due to the Federal Reserve’s shift in monetary policy. In fiscal year 2023, interest payments on the debt reached $711 billion, up from $534 billion in 2022 and $413 billion in 2021. This month, the projected debt servicing costs are at $825 billion, nearly matching the U.S. annual national security expenditure.
Sonal Desai, Chief Investment Officer at Franklin Templeton Fixed Income, commented, “The mistaken belief that we had entered a new era of low-interest rates is proving expensive, with higher prices and prolonged stress on diminishing state resources.” While a debt crisis is not certain, there is growing doubt that Washington will take the necessary steps to prevent one. Fitch Ratings has already expressed concern about governance standards, leading to a downgrade of the U.S. credit rating, while Moody’s has revised its outlook to negative, citing increasing political risk and social fragmentation.
Future Challenges and Outlook
The upcoming debate over the $3.3 trillion cost of renewing the 2017 tax cuts could trigger another bond market downturn and a potential credit rating downgrade as these cuts expire at the end of 2025. After the 2024 election, discussions about taxes are expected to intensify, with increased focus on “bond vigilantes”—bond traders pressuring Washington to address fiscal deficits by driving up Treasury yields.
Ed Yardeni, President of Yardeni Research, noted, “At that point, we may witness renewed pressure on the bond market to force action to curb the unsustainable path of the deficit.” This growing debt, compounded by higher interest rates, poses a significant risk. According to Congressional Budget Office projections, public debt as a percentage of GDP is set to rise from 98% to 119% by 2033 if current laws remain unchanged, and even higher if tax cuts are extended.
Market Implications and Strategies
Despite America’s strengths, including its global economic role and productivity growth, the lack of a clear plan to improve the fiscal outlook sets it apart from its “Aaa”-rated peers like Germany and Canada. Moody’s suggests that failing to address these issues could lead to a credit rating downgrade, signaling that macroeconomic weaknesses are undermining the Treasury’s status as a “risk-free” investment.
The potential return of “bond vigilantes,” who have been largely absent for 16 years, could further complicate the situation. The Federal Reserve’s past quantitative easing (QE) measures and historically low-interest rates have contributed to the current fiscal challenges. With true Treasury yields returning to pre-2008 levels, the fiscal outlook could be bleaker than current assessments suggest.
For businesses and investors, these developments mean potentially choppier waters ahead. According to Jurrien Timmer, Director of Global Macro Strategy at Fidelity, rising U.S. Treasury yields could create economic volatility and financial market instability. In such a scenario, businesses must brace for higher borrowing costs and potential economic downturns, while investors should consider strategies to mitigate risks associated with escalating debt and interest rates.