As recently as the early 1990s, America’s leaders cared a lot about how bond investors would react to their decisions. James Carville, a political strategist for Bill Clinton, famously said that he’d like to be reincarnated as the bond market, because “you can intimidate everybody.”
For most of the past two decades, the bond market has been remarkably docile. Yields overall have been low, and the term premium — the average difference between long-term and very short-term Treasury yields — declined to about zero, from more than 100 basis points before the 2008 financial crisis. The premium’s disappearance suggested an extreme lack of concern about the risk of higher inflation or the sustainability of the US government’s finances.
That’s set to change, for at least three reasons.
First, the economic context is evolving. During the slow-growth period that prevailed after 2008, bonds’ guaranteed interest payments provided a hedge against recession, and against the risk of short-term rates getting stuck at the zero lower bound. But since last year’s surge in consumer prices — which led to a 2-percentage-point increase in the yield and a 15% decline in the price of 10-year Treasury notes — they’re perceived as much more vulnerable to the risk of higher inflation.
Second, the US is borrowing too much. The Congressional Budget Office estimates that the federal budget deficit will exceed 5% of gross domestic product over the next decade, bringing the total federal debt held by the public to a record of 118% of GDP, exceeding the prior peak at the end of World War II. And that’s probably an underestimate, given that the CBO is making three optimistic assumptions: that the government’s longer-term borrowing costs will be lower than they are right now, that tax cuts enacted in 2017 will expire at the end of 2025, and that the current economic expansion will go on for another 10 years.
Third, neither President Joe Biden nor Congress is likely to address the government’s fiscal problems anytime soon. Although both the Biden administration and House Republicans are making the case for prudence, they couldn’t be further apart about how to proceed. Biden reportedly wants to raise $2 trillion over the next decade by increasing taxes on wealthy households and large corporations. Republicans, by contrast, want to slash spending -- but primarily through draconian cuts in crucial safety-net programs such as food stamps, rather than by reforming the big entitlement programs, Social Security and Medicare.
The main question, then, is when bond investors will recognize the risks and respond accordingly. When that moment comes, it will likely happen fast and be self-reinforcing. Flagging demand for Treasury bonds will push up the government’s borrowing costs, further worsening its finances and unnerving investors. The upward spiral in yields will persist until politicians are forced to compromise and act in a more fiscally responsible manner.
One potential trigger: the federal debt ceiling. This arbitrary limit on borrowing will likely bind sometime this summer, rendering the Treasury unable to meet all the government’s obligations. Congress has always managed to avert such a disaster in the past, but this time might be different: Republican House Speaker Kevin McCarthy could lose his speakership if he cuts a deal, and President Biden has said he won’t negotiate, because the debts in question represent tax and spending decisions that legislators have already made.
Failure to reach an agreement would shock financial markets, which are expecting a last-minute compromise as has happened in the past. Even if the Treasury manages to prioritize payments and avert an outright default on government debt, investors will wonder how long it can keep juggling. Also, the related sharp contraction in government spending would directly undermine the economy: Incoming revenue would probably be sufficient to cover only 65% to 75% of non-debt-service outlays.
Hitting the debt ceiling would be the absolute worst and dumbest way to address unsustainable budget deficits. One can only hope that politicians will somehow come to their senses and agree on a responsible fiscal consolidation, before the bond vigilantes force one.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley is a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics. A senior research scholar at Princeton University, he served as president of the Federal Reserve Bank of New York and as vice chairman of the Federal Open Market Committee.
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