On the Road to US Fiscal Ruin
In The Sun Also Rises, when one of Hemmingway’s characters was asked how he went bankrupt, he replied “first gradually and then suddenly”. As 30-year US bond yields climb to their highest level since 2007 in response to the country’s unsustainable public finances, we must ask whether something similar might soon be said of the United States. Presently the US seems to be going bankrupt gradually, and it would seem to be only a matter of time before it goes bankrupt suddenly.
There can be little question that the US public finances are on an unsustainable path that will end in tears. In the past, that has been the case of all too many other countries that allowed their public debt to get onto an unsustainable path. According to the Congressional Budget Office (CBO), the US budget deficit will exceed 6 percent of GDP as far as the eye can see in the years immediately ahead. That is the case even before considering Trump’s proposal to increase defense spending by $500 billion.
The CBO warns that as early as 2029, the US public debt will reach 107 percent of GDP or a higher level than prevailed at the end of the Second World War. In the interim, the US government will have to finance an annual budget deficit of around $2 trillion and rollover around $10 trillion in maturing debt each year.
Until recently, foreign central banks have been an important source of borrowing for the US government. Indeed, foreigners presently hold around 30 percent of all US Treasury bonds outstanding. However, in recent years, those central banks in general, and the Chinese central bank in particular, have been reducing the relative share of US Treasuries in their overall international reserve holdings. They have done so in part due to the weaponization of US financial policy against countries like Iran and Russia. More troublingly, they now seem to be concerned about the US government’s lack of commitment to low inflation as Trump repeatedly attempts to undermine the Federal Reserve’s independence.
One indication of a country getting into debt difficulties is that it increases the proportion that it borrows at short-dated maturities to cover its borrowing needs. In this connection, it must be troubling that the US government is increasingly covering its borrowing needs by the issuance of short-dated Treasury bills. Whereas over the past two decades Treasury bills amounted to between 15 and 20 percent of the government’s overall marketable debt, today that figure is around 22 to 25 percent. That increasingly exposes the country to rollover risk.
Another indication of a country heading towards bond market trouble is an increased reliance on more market sensitive lenders with shorter investment horizons. Here too there is reason for concern in the US government bond market. The Treasury is becoming more reliant than ever on short-term leveraged based financing from hedge funds and money market funds. It is doing so as long-term buyers, including the Federal Reserve, foreign central banks, and the banks, are becoming a less significant source of demand. While this might work well in normal times, it could be a source of vulnerability at a time of market stress.
Recent long-term bond yield increases are yet another sign that real trouble is brewing in the US bond market. Normally at a time of heightened geopolitical tensions, one would expect US bond yields to decline as investors sought the US bond market’s haven. Yet this is not what has happened this year to US long-term bond yields even at a time when the government has been funding itself increasingly at the short end of the curve. Over the past year, 10-year Treasury bond yields have increased by more than 75 basis points to their present level of around 4.65 percent while 30-year Treasury bond yields are now uncomfortably above 5 percent.
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