The 10-year Treasury yield set off roaring alarms about the U.S. budget when it surged to 5% last month. Now those warnings look like a fire drill. Federal Reserve rate hikes seem to be over for now, giving the bond market a reprieve and allowing a powerful S&P 500 rally to resume.
Enjoy it while it lasts. The next debt scare may be the real thing, and it could rock the U.S. economy and stock market.
Here's why: The Fed's historic turnabout, from enabling massive budget deficits to directing the sharpest rate hikes in 40 years, has seemingly broken the budget. Treasury market stress is almost certain to return.
The era of Fed quantitative easing and near-zero interest rates promoted carefree fiscal policies that led the U.S. to rack up $20 trillion in federal debt since the 2008 financial crisis.
Federal Reserve Fuels Red Ink
Exhibit A in the case of the broken federal budget is the deficit's surge in fiscal 2023, which ended Sept. 30. Unemployment was near a record low and GDP growth was strong. Under those conditions, the budget deficit usually shrinks. But it essentially doubled to $2 trillion, if you ignore accounting for Biden's student loan forgiveness that was struck down by the Supreme Court.
The Federal Reserve's fingerprints are all over the red ink. After the Fed sent more than $100 billion in interest on its bond portfolio to the Treasury in fiscal 2022, it had to halt those payments last year as bond prices fell. Having let inflation get out of the bag, an 8.7% cost-of-living adjustment stoked a $134 billion increase in Social Security checks.
Another roughly $100 billion went to FDIC bailouts, as banks like Silicon Valley Bank that loaded up on Treasuries when rates were ultralow became insolvent when Treasury yields surged. To top it off, the Fed hiking its key rate past 5% forced Uncle Sam to pony up an extra $177 billion in interest on the debt. That problem is destined to keep growing by leaps and bounds.
Debt Service Costs Skyrocket
With the Federal Reserve reversing its easy-money policies, the expense of servicing the national debt is exploding. Interest on the debt vaulted to $711 billion in fiscal 2023. That's up from $534 billion in 2022 and $413 billion in 2021. This month, debt service is running at an $825 billion rate. That's about what the U.S. spends on national defense.
"The misjudged confidence that we had entered a brave new era of low interest rates is costing us dearly now — first through a period of high inflation and now through persistent pressure on a government budget that already has precious little room for maneuver," wrote Sonal Desai, chief investment officer at Franklin Templeton Fixed Income.
While a debt spiral isn't inevitable, almost no one thinks that Washington will act to avoid one. Fitch Ratings, in August's U.S. credit rating downgrade, bemoaned "a steady deterioration in standards of governance." When Moody's cut its U.S. rating outlook to negative this month, it warned of "rising political risk to the US' fiscal position and overall sovereign credit profile" as political polarization thwarts budget deficit reduction.
The catalyst for another bond-market rout — and possibly another U.S. credit-rating downgrade — could be the coming debate over the $3.3 trillion cost over 10 years to renew parts of the 2017 Trump tax cuts. Those cuts are due to expire at the end of 2025.
Bond Vigilantes
That tax debate won't get serious until after the 2024 election. But you can expect to hear plenty from "bond vigilantes" — a term coined by Wall Street strategist Ed Yardeni in the 1980s for the bond traders who made Washington pay for fiscal excess by driving up Treasury yields.
"At that point we can have renewed pressure on the bond market to the extent that nothing is being done to alleviate the reckless path the deficit is on," Yardeni, president of Yardeni Research, told IBD.
The "unsettling" thing, Yardeni said, is that "the bond vigilantes may be more powerful than ever because there's more debt than ever and it's compounding at a faster rate because of higher interest rates."
The Congressional Budget Office's latest projections show that under current law — meaning all of those 2017 tax cuts sunset on schedule — public debt as a share of the U.S. economy would rise from 98% to 119% by 2033. The Committee for a Responsible Federal Budget estimates that extending all of the tax cuts would raise that share by 10 percentage points. Under that scenario, the projected annual budget deficit in 2033 would exceed $3 trillion, or 8% of GDP. That's unheard of, except during war or in the wake of a recession.
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No Plan To Rein In Budget Deficits
For reserve-currency countries like the U.S., for which default isn't a real risk, Moody's is less concerned about a high debt-to-GDP burden. Instead, it's focused on another metric reflecting its willingness to take action to curb escalating debt costs.
In 2022, the government spent 10 cents of every dollar in tax revenue on servicing the national debt. CBO projections show interest expense doubling to 20 cents on the dollar by 2033. But Moody's sees that as too optimistic. It sees 26 cents of each dollar in taxes going to debt service. Moody's says that would be the kind of fiscal stewardship consistent with a C-type credit rating.
America's unique strengths, including the central role of the dollar, solid productivity growth and technological leadership, afford Washington more leeway, Moody's says. But the lack of any plan to improve the fiscal outlook "is fundamentally different" from most "Aaa"-rated peers, such as Germany and Canada.
A credit-rating downgrade, if it comes to that, would signal that fiscal weakness will erode Treasuries' "preeminent safe-haven status."
Wall Street barely flinched after Moody's shot across the bow on Nov. 10 because the bond market had already flashed its own warning.
"The Bond Vigilantes may be saddling up," Yardeni wrote Aug. 3, heralding their return after a 16-year hiatus.
Federal Reserve QE Era
Bond vigilantes' long absence was marked by ultralow rates, low inflation and tepid demand ushered in by the 2008 financial crisis.
The Fed began its quantitative easing as an emergency market stabilization tool in late 2008. The central bank bought up government-backed mortgage securities to keep housing finance flowing. Yet with its key interest rate already at zero and the recovery unusually subdued, the Federal Reserve announced a second round of asset purchases — this time Treasuries — and then a third.
Joe Gagnon, senior fellow at the Peterson Institute for International Economics, argues that the Fed "really should have been even more aggressive," saying it took too long to achieve its full-employment mandate. The unemployment rate wouldn't fall to 5% until late 2015.
'Crazy' Not To Swell Budget Deficits
Yet QE, which held market interest rates low despite massive federal deficits, made a mockery of fiscal responsibility.
Conventional wisdom came to hold that "governments would be crazy not to deficit-spend more, since they could borrow pretty much for free," wrote Franklin Templeton's Desai. And for a while, it seemed to work.
Federal Reserve's 'Massive Mistake'
Even as public debt nearly tripled as a share of the U.S. economy from 2007 to 2021, net interest outlays actually dipped. That's because the average interest rate on debt held by the public fell from 4.7% of GDP to 1.4%.
Then came the Federal Reserve's "massive mistake," as Gagnon sees it, of keeping its pedal to the metal in 2021, despite gargantuan fiscal stimulus to speed Covid recovery. The biggest inflation outbreak in 40 years ensued, spurring rapid-fire Fed rate hikes to stem it. The interest rate hikes steadily lifted the Treasury's average borrowing rate to 2.3% by the end of 2022 and 3.1% as of October.
About $8 trillion worth of debt held by the public is set to mature over the next year. The Treasury will have to reissue that sum. The key question is at what interest rate.
Fed Rate Cuts Won't Be Enough
Following soft recent jobs and inflation data, markets expect the Federal Reserve to cut its key rate a full point in the coming year to 4.25%-4.5%. That would reduce the risk of a near-term fiscal derailment over runaway debt-service costs.
Yet it won't take sky-high rates to blow up the budget. Moody's projection of soaring debt-service costs assumes that the 10-year Treasury yield will settle back to around 4%. But the high stock of national debt is only about half the reason the budget deficit may hit 8% of GDP in a decade. The other half is a structural fiscal gap, with tax revenue insufficient to pay for the rising cost of Social Security and Medicare.
National defense, income-security and health care programs will continue to take up close to 100% of tax revenue, CBO 10-year projections show. That's even if most Trump tax cuts expire. Almost all the rest of federal spending will go on the government's credit card. That includes government salaries, veterans' health, border security, Pell Grants, National Institutes of Health research, infrastructure projects and more.
Fiscal Responsibility? Not Yet
Could fiscal responsibility make a comeback, now that the bond vigilantes have awakened? Not as long as big budget deficits are a realistic alternative to tax hikes on the right and spending cuts on the left. That will take significantly higher 10-year Treasury yields than we have today.
Consider this litany of reasons not to worry about the deficit from Dean Baker of the liberal Center for Economic and Policy Research. The inflation surge is fading. Addressing climate change will do a lot more for future generations than cutting the budget deficit while ignoring climate change. Japan has a far higher debt load than the U.S. and it's getting by OK. And artificial intelligence could ignite a productivity boom that spurs faster growth and makes our debt more manageable.
Treasury Yield Fire Alarm
The 10-year Treasury yield's surge to 5% in October — up 1.5 percentage points over three months — set off alarm bells that the scale of government debt issuance was overtaking the market's willingness to absorb it. That seemed to raise a risk of still-higher yields ahead.
News that Treasury will borrow less than expected in Q4 and further signs of easing inflation pressures have sent government bond yields tumbling over the past month. Yet it appears that the bond vigilantes are biding their time, rather than going back into hibernation.
Real Treasury Yields At Pre-2008 Levels
Confirmation of bond vigilantes' return came in September. That's when the yield on 10-year TIPS, or Treasury Inflation-Protected Securities, made a clear break above 2% for the first time since 2007. Though off its October high of 2.5%, the 10-year TIPS yield is holding at 2.20%. That's after spending most of the QE era below 1% — and below 0% for some of it.
The TIPS yield subtracts the inflation rate, making it synonymous with the real 10-year interest rate. The challenge the federal government will face in paying its bills is that real Treasury yields have largely reverted to pre-financial-crisis levels.
A number of factors help explain the reversion. Federal Reserve bond buying that squelched market signals has given way to reducing its assets. Baby boomers have gone from saving for retirement to living off their savings. Offshoring of production has turned to onshoring, with massive investment in chip manufacturing, electric vehicle supply chains, artificial intelligence and more. In general, funding has been scarcer relative to the demand for it.
What's unknown is where real interest rates will settle. Franklin Templeton's Desai thinks the neutral Fed policy rate — neither accommodative nor restrictive — may be at least 4%. That implies at least a 2% neutral real rate.
The term premium for holding bonds longer could add another 1 percentage point to the 10-year Treasury yield, putting it around 5%, she says.
If that's right, then the fiscal outlook is even worse than Moody's thinks.
'Choppier Seas' For U.S. Economy, S&P 500
What does all this mean for the U.S. economy, Fed policy and the S&P 500?
Jurrien Timmer, Fidelity's director of global macro strategy, envisions a scenario in which U.S. Treasury yields stretch, not to the breaking point, but enough to create "choppier seas" for the economy and financial markets.
Over the past several decades, the ongoing fall in interest rates and inflation, with little volatility, produced "elongated cycles, with a recession every 10 years, if that," Timmer told IBD.
The Federal Reserve could pivot quickly and pull out all the stops, if needed, without worrying too much that inflation would take off.
Federal Reserve May Not Ride To Rescue
But going forward, Timmer says, the Fed "might have to be much more muted in its reaction" to economic weakness. Higher rates might be quicker to choke off growth, leading to shorter expansions.
What if the 10-year Treasury yield shoots to 6%, threatening runaway interest costs and an economic slump, as bond vigilantes rebel?
In that case, Wall Street shouldn't necessarily expect the Fed to ride to the rescue with rate cuts, Gagnon says. That's especially true if massive and growing fiscal deficits prove inflationary, as he expects they will.
"The bottom line is inflation is going to be at 2% and the Fed is going to make sure that happens. It doesn't matter what interest rate Treasury has to pay," said Gagnon, who served in various Fed roles over two decades.
Even if the economic toll from a rise in Treasury yields sends inflation below 2%, the Federal Reserve might not be quick to roll out the heavy artillery. The Fed's modus operandi still treats QE as a last line of defense — after interest rates are cut to zero. In the new old normal, in which a 4% fed funds rate is neutral, that might take a while.
Fed End Game?
Still, some see that QE end game as inevitable, with the Federal Reserve essentially carrying some of the debt it enabled. "We will need QE in some form again, and in big size, in the future to control the rise in debt," Deutsche Bank strategist Jim Reid said.
Others think the Fed might eventually resort to yield curve control, dictating interest rates on the debt rather than influencing them with bond purchases. That's the approach it used to finance World War II, before the Fed got its independence in 1951. It's what the Bank of Japan uses today.
"The real acid test will only come if Treasury bond prices fail to rally on bearish economic data, such as a sudden collapse in payrolls or, for that matter, a stock market crash," wrote Jefferies strategist Christopher Wood. "This is the context where it becomes much more likely that Washington will end up resorting to Japanese-style yield curve control policies."
