Logic Doesn't Work With Bonds and U.S. Deficits
Bigger deficits mean the U.S. government will likely need to sell more debt to finance the shortfall.
(Bloomberg View) -- When the topic of rising budget deficits is discussed, the natural inclination is to worry about their bearish impact on interest rates. The logic is reasonable. Or is it?
Bigger deficits mean the U.S. government will likely need to sell more debt to finance the shortfall, and when there’s more of something its price tends to drop assuming steady demand. In the case of Treasuries, more debt should mean that stimulus is coming in some form, which presumably should boost the economy and bonds less appealing relative to riskier assets. True, more debt stemming from a decline in revenue during a recession is a separate event, but that situation doesn’t usually last long and the deficit often narrows in a recovery.
And given that the U.S. is arguably in pretty good economic shape -- the lowest unemployment since 2001 and steady, albeit sluggish, gross domestic product -- a big increase in the budget deficit for fiscal stimulus purposes doesn’t seem quite necessary or prudent, as many would argue. That’s especially so when the Congressional Budget Office already forecasts that the deficit will expand sharply, and these forecasts came before the current tax "reform" ideas were proposed by the Trump administration.
The chart below shows the current state of the budget deficit as a percentage of GDP with a forecast to 2027 and the overall dollar amount. The CBO assumes real GDP growth of about 1.8 percent for the next 10 years and potential labor force productivity growth of about 1.3 percent. These seem reasonably conservative. Note that debt is currently 74.9 percent of GDP, going to 90 percent before any deficit-boosting tax plan. That’s debt held by the public. The overall federal debt load is about 106 percent of GDP.
Note, too, that the average maturity of Treasury debt has been rising, reaching 71 months as of June, from 49 months in 2008. The Treasury’s most recent report to the Treasury Borrowing Advisory Committee has it increasing to almost 82 months, or 6.75 years, in a decade. Assuming those projections hold, there will be more longer-maturity bonds outstanding relative to today. And that’s before the Trump administration introduces bonds maturing in 40 years or more, which it has hinted could happen and is something I anticipate, if for no other reason than to meet demand from foreign pension plans and to mimic the debt issuance seen in other sovereign markets.
You get the picture: a lot more Treasuries and a lot more duration. But is this really bearish for interest rates? Probably not, when you consider the structure of the bond market. If the weighting of Treasuries as an asset class is going up relative to others, then an index-based investor will need to buy incrementally more Treasuries to keep pace. In other words, if the market currently has a 36 percent weighting in Treasuries and that rises to, say, 40 percent in a few years, then investors will need to buy more Treasuries.
There’s no denying that over the last several years investors have overweighted other asset classes, especially credit, at the expense of Treasuries given the lack of volatility in markets, an environment where interest rates have been relatively steady and the incremental yields investors can obtain by taking on more risk. Thus, the starting point is already underweight in an asset class that is growing. That’s bullish.
The chart below was provided by Ian Lyngen and Aaron Kohli, the fixed-income strategists at BMO Capital Markets. (This is something Ian and I put together conceptually when we worked together at other firms and so I take a little credit for the idea.) It’s a snapshot of the taxable bond market to illustrate my point. Between the rising deficit, the risk of a rising deficit with tax cuts, and the Fed’s goal of balance-sheet reduction, it’s a safe bet that Treasuries are going to go up in this chart.
Now add to that idea the increasing average maturity of Treasury debt and what you have is a scenario where investors need to buy both more Treasuries and more duration to keep pace with changes in their benchmarks. I haven’t even touched on investor moves to more passive instruments such as exchange-traded funds, but it’s safe to assume that will add to demand.
Yes, I worry about increased Treasury issuance and increased duration -- logic dictates that. However, there is a very strong offset that might balance out those worries or, potentially, force investors to buy, keeping deficit-driven bearishness at bay and the saga of lower for longer yields in play for years to come.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
David Ader is chief macro strategist at Informa Financial Intelligence. He was the No. 1 ranked U.S. government bond strategist by Institutional Investor magazine for 10 years.
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