by Joe Herrle, CFA
Vice President, Alternative Assets
Last week, the benchmark 10-year U.S. Treasury bond yield reached 4.8%, the highest since June 2007. Bonds reached another milestone last week when the aggregate bond index posted its 38 consecutive monthly drawdown, marking this the longest bond bear market on record. The specific forces pulling the levers of the bond market are numerous, and the math is complex. However, we can confidently say the root cause is inflation driven by unprecedented amounts of fiscal and monetary easing, leading to the steepest rate hike path in history. With this simple fact laid so bare, one would think policymakers would get the picture; the Fed certainly does.
The Federal Reserve is doing its job by hiking rates to wrangle high inflation, and we have every reason to believe they will eventually win the fight. These high rates will slow the economy directly by making it more expensive to borrow money for purchases like cars and homes. But, these higher rates don't just make it harder to borrow for main street: it also makes borrowing for the government much more expensive. While the U.S. consumer drives the economy by accounting for 70% of GDP, the federal government having a higher cost of borrowing has meaningful implications for economic growth in the future.
The U.S. has about $31 trillion of debt outstanding with an average coupon of 2.6%. The Treasury will refinance a third of that in the next 12 months at an average rate of approximately 5%. This will push the interest expense to GDP ratio above the all-important 14% level we hit in July. This is a critical level because history has shown that when federal interest payments exceed 14% of annual GDP, deficits and debt begin to matter for policymakers as spending money we don't have has a real cost, and austerity measures are implemented.
Since crossing the Rubicon of 14%, ratings agency Fitch downgraded U.S. debt, the Treasury needed an additional and unexpected $250 billion of debt issuance in Q3. In fact, new debt issuance is now so large the Treasury is increasing coupons for the first time in more than three years and Republicans removed the Speaker of the House for not cutting spending enough (among other reasons). Unsurprisingly, the 10-year U.S. Treasury yield has moved from 3.96% to 4.8% over the span of just two months.
This slowly deteriorating fiscal picture is reminiscent of a passage from W.B. Yeats's poem "The Second Coming:" "Turning and turning in the widening gyre, The falcon cannot hear the falconer." However pessimistic this all sounds, we must remember the reality is not as dire as these events may imply. Powerful forces are at play that can keep rates from spiraling out of control and reverse this trend. Namely, our high-functioning financial markets can keep fiscal policymakers in check, and the USD's status as the world's reserve currency will give us room to maneuver until inflation, rates and deficits reach an appropriate balance.
The U.S. has the world's deepest, most liquid and well-functioning financial markets. As such, it is an efficient pricing mechanism that weighs risks and rewards and balances supply with demand. When the Treasury issues too much debt, investors can send a clear message by demanding a higher rate to own that debt. This causes rates to increase, thereby raising the cost of borrowing. Large investors who demand significantly higher yields in protest of issuers' policies are referred to as "bond vigilantes," and over the past 50 years, there are numerous cases of them having an impact.
For example, driven by concerns about government spending, from October 15, 1993, to November 7, 1994, the 10-year U.S. Treasury yield climbed from 5.2% to 8.1%. With guidance from economic advisors, the Clinton administration and Congress tried to reduce the federal budget deficit. Eventually, the yield dropped to 4.16% on October 5, 1998. We could be witnessing this right now from investors, and it is a good thing: it means our markets are behaving in a healthy manner.
The Federal budget imbalance has also recently raised questions about the U.S. dollar remaining the world's preferred reserve currency. Dollar primacy has allowed our country to grow the economy and will remain essential for our government to continue financing debts. Make no mistake: the dollar's dominance will continue, remaining a safe haven, the preferred store of value and the most favorable currency to conduct business in. Take, for example, the fact that the USD comprises 60% of all the money in the world combined. Furthermore, over the last 10 years, the dollar has appreciated against all 115 recognized currencies in the world. Lastly, there are no good alternatives to the dollar as the primary reserve currency. There have been suggestions that the Chinese yuan could replace the dollar as China's economy approaches the largest in the world. But no matter the size and strength of the economy, global reserve banks and businesses do not want to have the bulk of their savings in a currency controlled by an authoritarian government.
In the face of a more challenging fiscal situation, given the dollar remains king and our markets function as they should, where does that leave us? The path forward will likely mean higher taxes and less spending, as this is the most immediate and obvious solution. Reigning in fiscal profligacy while increasing tax revenue will put a damper on the economy. But, in the long run, America's uncanny ability to innovate, increase productivity and grow will ultimately keep the train on the tracks and moving in the right direction.
Takeaways for the Week
The labor market is still hot. Today, the Labor Department revealed employers added 336,000 jobs in September, roughly double what analysts had forecast. The unemployment rate remained unchanged at 3.8%
Wage gains and labor force participation, however, did not show marked increases, which eased fears of a wage/price spiral
Equities rallied in response to the report as it does not give the Fed a reason to hike rates further. The S&P 500 is up about 0.5% on the week after being down as much as 1.7%