The American people have been through, politely speaking, a lot over the past several years. From the Covid pandemic itself, to the deep scars left by the lack of social and educational functions, to the massive inflation afterwards that has contributed to three straight years of declining real incomes...it's been an exhausting and frustrating period of time.
Unfortunately, it isn't over yet. In fact, like being trapped in a video game where each level gets progressively more difficult, the next chapter may be even more challenging. Because now, markets are freaking out over the government's fiscal problems. And we all know that might be the hardest thing for this country to try and solve.
Bond yields are rising again this morning. The 10-year Treasury yield already hit 4.735%, after punching above 4.7% yesterday for the first time since 2007. It's not even going out on a limb anymore to say 5% could be next. This, despite all the technicians saying the move is already "overdone" and should start to reverse. But it's just not doing so. Similar story for the 30-year "long" bond, which is nearing 4.9%.
The single biggest reason rates are rising is because the U.S. fiscal picture has been much worse than expected this year. The economic data have stopped getting noticeably better in recent weeks, even as the speed of the upward move in yields has increased. Inflation expectations are not getting worse; they're unchanged. It's all been a sharp jump in "real" yields, which by one metric have gone from as low as 1% in April to nearly 2.4% today.
And the biggest change since April, in terms of what could affect "real" yields, is not the U.S. long-term productivity picture, or demographics, or de-globalization, or what have you. It's the sharp increase in the budget deficit. Back in April, for instance, Goldman expected this year's deficit to be $1.6 trillion--already a hefty sum. But it actually came in at $2 trillion, and would have been $2.3 trillion if not for the Supreme Court's last-minute cancellation of the president's student loan forgiveness plan.
And the problem is, there's no one-off "reason" for that sky-high figure, which is a doubling from last year and, at 7.4% of GDP, the largest non-emergency deficit we've ever run. Revenues have fallen back to historical averages after a surge in the two previous years, so that's not helping. But spending meanwhile remains about three points higher than it was pre-pandemic, and for a wide variety of reasons, from higher Medicare and Social Security payments, to a lack of Fed remittances, to FDIC spending on the bank bailouts, and so forth.
Do you see anything in there that looks easy to fix? I don't. Markets don't, either. Entitlement reform is literally the hardest thing this country might have to undertake. No doubt we'll see another "Greenspan Commission" which will pull back benefits as painlessly as possible, mostly affecting higher earners. But as Dan Clifton of Strategas noted yesterday--as have many others--we're heading into an election year. About the worst time to tackle such issues. It will have to wait, and hence investors remain rattled about how quickly we can close the deficit.
Not helping is the fact that interest costs themselves are now the biggest driver of the budget deficit going forward. That's right; interest rates have been rising because the fiscal picture is worse than expected (too much Treasury supply right as the structural buyers of that debt have disappeared), and the more that rates rise, the worse the deficit will get, in what's been termed a "fiscal doom loop."
More than half of the budget deficit in the coming years is expected to result from higher interest payments. CBO thinks the deficit will average about 6% of GDP through 2033, with 3.1 points of that from interest payments on the debt. As a result, deficits will be running nearly twice as high as the historical average of 3.6%. And we haven't seen deficits of more than 5.5% for more than five years in a row since at least 1930, they note.
And the pressure on the deficit will only keep growing so long as (a) interest rates are higher than nominal GDP, and (b) the primary, underlying deficit is running higher than levels that would keep the debt pile from rising. While no one is sure what will happen with interest rates, it is definitely the case that primary deficits are so large the debt load will keep growing.
We are running around a 3% primary deficit right now (meaning, ex-interest payments), but we need to get that down to only about 0.5% to stabilize our current debt-to-GDP ratio, according to Goldman's Alec Phillips. Unfortunately, CBO is projecting 3% primary deficits for the next decade, meaning, if we don't quickly close the gap between spending and revenues, the debt load will keep growing, and interest costs will keep on rising, and the deficit will thus stay elevated, which grows the debt load even more.
So again, we now need Washington policymakers to quickly close the budget deficit in order to keep rates from further going haywire. The 10-year yield is one of the most important metrics in global markets; it affects everything from bank solvency to U.S. mortgage rates. And it's been soaring over the past month.
Either D.C. needs to enact difficult policy changes that will drastically reduce the amount of future Treasuries coming onto the market, or a major new buyer (ahem, central banks?) needs to re-emerge. This may be the most exhausting chapter yet in this story.
See you at 1 p.m!
Kelly
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