Both developed and developing economies alike are in a precarious position.
August 8, 2023
A perfect storm of events has sent longer maturity U.S. Treasury yields soaring. Last week, the 10-year note reached 4.20%. Five weeks ago, at the end of June, the U.S. Treasury 10-year note yielded just 3.70%. Similarly, the 30-year bond, within spitting distance of eclipsing its high of 4.38% in October 2022, recently hit 4.32%.
Five events collided as the week unfolded causing yields to spike, some of which are unlikely to reverse anytime soon:
Bond market participants have had to reverse course and unwind their bets on a recession.
The Bank of Japan (BOJ)’s shift of its yield curve control (YCC) reverberated around the world. Japan’s central bank had previously targeted the Japanese government bond (JGB) yield at 0.50% but changed and said that rate was no longer a ceiling. That pushed the JGB 10-year to 0.66%, its highest in decades, before the BOJ had to step in and purchase bonds to prevent the yield from further spiking. Over the last five days, the JGB 10-year has traded in a range of 0.60% to 0.66%.
The shift reduced the relative attractiveness of sovereign debt elsewhere. That pushed up the yields on sovereign debt the world over, including those for U.S. Treasury bonds.
The resilience of the economy through the Federal Reserve’s most rapid rate hiking cycle since the 1980s has raised the probability that the U.S. will experience a soft landing. The recent cooling of inflation and wages further fueled those hopes in recent weeks. That is the exact opposite of what most bond market participants were expecting.
In response, bond market participants have had to reverse course and unwind their bets on a recession. The uncoiling of those hedges exacerbated the upward pressure on bond yields. Indeed, the yield curve, which tends to be a bellwether of the economy’s health, flattened dramatically over the last week.
Then, as if to add insult to injury, the ratings agency Fitch downgraded the credit rating for the U.S. debt from AAA to AA+, citing a deterioration in governance. There is also concern over rising deficits, which are already tracking well ahead of last year, largely in response to a sharp deterioration in tax revenues. The deterioration in governance and the U.S. fiscal situation are not breaking news but reinforced the shift in sentiment in the bond market triggered by other events that happened the same week.
Year-to-date (October through June), the U.S. Treasury fiscal deficit is running well ahead of last year at $1.393 trillion for FY 2023 versus $515 billion in FY 2022. A predominant reason is that individual income tax receipts are coming in weaker, totaling $1.694 trillion for FY 2023 YTD versus last year’s higher take of $2.135 trillion.
How serious is the situation cumulatively? The Congressional Budget Office (CBO) projects the federal debt-to-GDP ratio doubling from an estimated 98% in 2023 to 185% by 2052. What’s worse is that servicing this debt will be a primary driver of those deficits.
The CBO projects interest payments will total $663 billion in FY 2023, climbing to $1.4 trillion by 2033. By 2033, interest expenses will outstrip spending on key programs such as Medicaid, income security programs such as the Supplemental Nutrition Assistance Program (SNAP, or food stamps), defense and nondefense discretionary funding.
Was the downgrade justified? Many were taken aback. The U.S. is still the reserve currency of the world, despite predictions of its demise. It is not expected to default on its debt anytime soon.
Treasury Secretary Janet Yellen was one of many to condemn the action. However, the Federal Reserve, which issued a joint communique with the Treasury and the Federal Deposit Insurance Corporation the last time the U.S. faced such a junction has been surprisingly quiet.
In 2011, the Fed worried that banks would be seen as undercapitalized, given the downgrade then to Treasury debt by S&P Global Ratings (formerly known as Standard & Poor's). Banks are forced to use Treasury bonds to ensure that they have the capital buffers necessary to deal with deposits, which can be withdrawn at any time. A sudden downgrade could destabilize the whole banking system, which was still struggling in the wake of the global financial crisis.
Last, but by no means least, the U.S. Treasury is still catching up on debt it could not issue during the showdown over lifting the debt ceiling last Spring. The Treasury announced it would auction $103 billion in longer term Treasury securities this quarter, comprising three, ten and 30-year securities. That was slightly above the expectation among primary dealers for $102 billion in new issuances and was significantly above the $95 billion auctioned in May.
Treasury issuances are expected to remain elevated during the November and February auctions. Add the Fed’s quantitative tightening – it is allowing $60 billion a month in Treasury bonds to roll off its bloated balance sheet – and it is not surprising that the bond market was roiled.
Foreign holdings of Treasury debt have been shifting over the last four years. China, which was the largest buyer of Treasury bonds in the 2010s has started to unload some of its holdings. Japan surpassed China as the largest foreign holder of Treasury bonds in 2019 but is now unloading some of those holdings. The U.K. has picked up some of that slack, tripling its holdings of Treasury bonds between 2017 and May 2023.
Foreign Holdings of U.S. Treasuries
End of period, $ trillions
End of period, $ trillions
Source: KPMG Economics, U.S Department of the Treasury
A Treasury 10-year note with a 4% handle is something market participants have not seen in 15 years, since 2008, except briefly last October. While shorter term money market yields are even loftier, returning near 5.50%, corporations, insurance companies and pension plans have longer duration liabilities to offset. Although foreign players may be losing their appetite for longer-term Treasuries, we expect domestic buyers to step in and increase their Treasury investments to reap the benefits of a 4% or higher return (e.g.; Treasury 20-year at 4.36%). The payoff will last for many years to come and is considerably more than the 2.3% average for the 10-year yield from 2009 to 2021.
The surge in debt levels is not solely a U.S. phenomenon. Both developed and emerging market countries are experiencing an explosion in debt and deficits (see table). The public sector has taken on a massive amount of debt to counter the effects of the pandemic and the war in Ukraine. That, combined with the debt remaining from the global financial crisis, led to much higher debt-to-GDP ratios than prior to the pandemic. As inflation accelerated and rates rose, that elevated the burden of debt service, so solvency issues arose. Countries that have faced depreciation in their currencies now have higher debt service obligations and could face higher inflation as the U.S. exports its inflation abroad.
Countries that are most at risk today of sovereign debt default or currency crises are those that are dealing with three major issues: high levels of sovereign debt, currency depreciation and hyperinflation. Countries that have already defaulted this year or were already in default include Argentina, Venezuela, Russia, Sri Lanka, Pakistan, Lebanon, Mozambique, Chad, Ethiopia, Ghana and Zambia. More countries at high risk include Türkiye, Colombia, Tunisia, Egypt, Kenya, Nigeria and Zimbabwe.
Both developed and developing economies alike are in a precarious position. Though global financial conditions have eased since earlier this year, higher borrowing costs have raised the risks for debt distress in vulnerable countries. The latest International Monetary Fund (IMF) Fiscal Monitor shows debt as a percentage of GDP remaining well above pre-pandemic levels through at least 2028.
The risk in this debt lies in connections between the higher risk countries and the U.S. To avoid default, many of the higher risk countries have borrowed not just from the IMF, but from China, the G20 Common Framework and the World Bank. Other methods used to avoid contagion have included liquidity swap lines via the Federal Reserve or U.S. Treasury Exchange Stabilization Fund, both of which were used during the 2008 Financial Crisis.
The credit tightening triggered by the rise in yields is already affecting home buyers in the U.S. The 30-year fixed rate mortgage rate jumped to 7.40% early this week, the highest since 2000. The prior high in mortgage rates was 7.35% in November 2022; the chill in housing was immediate. In the second half of 2022, residential investment plummeted by 26% on a seasonally adjusted annual rate basis. The upward movement in rates will likely put more homebuyers out of reach from moving into a new or existing home.
Mergers and acquisitions could also be curbed, after showing green shoots. Much depends on how high rates go and whether they persist at the levels we are seeing. We believe the 10-year will be sticky around 4% for the balance of this year. Next year, we project the 10-year yield to decline to 3.20% by the fourth quarter, which is predicated on our forecast that the Fed could begin to cut interest rates, starting in May 2024. But given the resilient economy to date, we do not expect the 10-year yield to fall below 3% in 2024.
For some time now, Federal Reserve policymakers have been communicating that policy rates would remain higher for longer. The Fed’s monetary policy actions more directly impact the front end of the yield curve while bond yields are determined by the actions of global market participants. The spike and perhaps staying power in longer term U.S. Treasury yields could be a harbinger of what is to come in the months and quarters ahead. What happens in the U.S. doesn’t necessarily stay in the U.S. any more than it stayed in Japan. Higher rates and rising debt look to be an increasingly global phenomenon - a sea change from decades past and conditions that may continue even after the initial effects of the perfect storm subside.