After 25 years of "ultra-low interest rates," the market finally begins to pay attention to the "high US deficit."

When US interest rates continue to rise, investors begin to pay attention to and worry about the high fiscal deficit in the US.

Analysis points out that the US Treasury has become a source of risk. Although the US will not default and will not fail to sell enough bonds in the next government bond auction, the size and upward trajectory of US debt, as well as the lack of political corrective measures, now pose a threat to the US market and economy that has not been seen in at least a generation.

This is the result of the sudden sharp rise in US Treasury yields in recent weeks, otherwise this cannot be explained: the inflation situation has slightly improved, and the Federal Reserve has hinted that its rate hike work is nearing completion.

The term premium, which refers to the long-term bond yield being higher than the short-term bond yield, has been rising faster for US long-term bonds compared to short-term bonds recently, which is unrelated to inflation or short-term interest rates. There are many factors that affect the term premium, and the continuously rising government deficit is a major factor.

The question is, why did this impact only become apparent now when the US fiscal deficit has been large for many years?

The Happy 25 Years is Over

For a long time, the orthodox view in economics has been that the growth of the deficit pushes up long-term interest rates. However, Riccardo Trezzi, a former Federal Reserve economist who now runs his own research company, pointed out that in the past 20 years, interest rate models that include fiscal policy have not been effective.

This is not difficult to understand. Because the Federal Reserve is concerned about low inflation and stagnant economic growth, it has maintained interest rates near zero while continuing to purchase government bonds (i.e. quantitative easing). The weak demand for private credit has overwhelmed any concerns about the deficit.

Mark Wiedman, Senior Managing Director at BlackRock, said:

"We have had a happy 25 years without worrying about this issue."

However, today, the Federal Reserve is concerned about high inflation and has stopped purchasing bonds, and in some cases is reducing its bond holdings (i.e. quantitative tightening). Suddenly, fiscal policy has become important again.

Markets Sometimes Experience Sudden Volatility

Analysis points out that the deficit can gradually or suddenly affect interest rates. Investors who are required to buy more bonds gradually make room in their portfolios by reducing purchases of other assets such as stocks. Eventually, the risk-adjusted returns of these assets tend to balance out, which means that bond yields will be higher and stock price-to-earnings ratios will be lower. This has been happening over the past month.

However, markets sometimes experience sudden volatility, such as the Mexican threat of default in 1994 and the Greek default in practice a decade later. Unlike Mexico or Greece, even in countries that borrow in their own controlled currency, interest rates may be constrained by the deficit, such as Canada in the early 1990s and Italy in the 1980s and early 1990s.

The US is not Canada or Italy. It controls the world's reserve currency, and its inflation and interest rates are mainly driven by domestic factors rather than external factors. But on the other hand, the US has also used these advantages to accumulate huge debts and deficits, which are much larger in scale than those of other economies.

There are currently not many signs that this has caused a backlash. Investors still expect the Federal Reserve to bring the inflation rate down to its 2% target. The inflation-adjusted yield on US government bonds is 2.4%, which is comparable to the mid-2000s of this century and lower than the 1990s when US government debt and deficits were much lower. However, sometimes bad news accumulates under the noses of investors until something catches their collective attention. "Will there be a day when all the headlines are about the unsustainability of the US economy?" Wiedman asked.

He said:

"I haven't heard global investors say that today. But is it possible? Of course, such a shift in pattern is possible. It's not that no one is buying US Treasury bonds, but they are demanding higher yields."

It is worth noting that recently, as US bond yields rose, Fitch Ratings downgraded the US credit rating, the US Treasury Department increased the size of bond auctions, analysts began to raise their forecasts for the US fiscal deficit this year, and the US Congress came close to a government shutdown due to the failure to pass spending bills.

Cutting the deficit becomes increasingly difficult

Barclays analysts pointed out last week that, after excluding accounting factors related to student debt, the US deficit as a percentage of gross domestic product (GDP) will exceed 7% in the 2023 fiscal year. This is larger than any year since 1930, except during times of war and recession.

Barclays added that high debt levels occur during periods of low unemployment and strong economic growth, indicating that "deficits could be much higher" under normal circumstances.

Fiscal policy has clearly started to take effect abroad. Last autumn, the UK's proposed tax cut plan caused a surge in UK bond yields, leading to the cancellation of the proposal and the resignation of the Prime Minister. And since the Italian government postponed reducing the deficit to below European guidelines last week, the country's bond yields have been rising.

As mentioned earlier, Trezzi stated that the European Central Bank has purchased over 100% of Italian government bonds in the past decade, but this situation is about to end.

Trezzi said that foreign investors concerned about inflation and deficits have been selling Italian bonds, while Italian households have been buying.

"It is still unclear how long households can offset foreign selling in the event of an economic downturn."

In the United States, both former President Trump and current President Biden have signed deficit reduction bills, but their respective parties have promised not to cut the two largest expenditure items, healthcare and social security, nor to increase taxes on most households.

Investors will also note that the Republican Speaker of the House was just ousted by his own party rebels for passing a bipartisan spending bill to prevent a government shutdown.

Indeed, the hardliners in the Republican Party want to reduce spending. But Barclays pointed out that a government shutdown represents "an erosion of governance" and is not the practice of a country trying to appease the bond market.