The U.S. fiscal outlook is deteriorating. Wall Street doesn’t seem bothered.
U.S. government bonds rallied this past month on the same day that the Congressional Budget Office said that it expects the fiscal 2024 budget deficit to reach $1.9 trillion—up from $1.7 trillion last year and its previous estimate of $1.5 trillion. A broader rally has pulled Treasury yields well off their highs from 2023, despite a series of jumbo-sized debt sales needed to fill the gap between the government’s spending and revenue.
That is surprising some analysts, who thought the growing debt pile might spark more market disruptions. Here is a look at the challenges facing the Treasury market, and how it has (so far) managed to meet them:
Unusually large
A larger deficit means the government needs to sell more Treasurys, and right now that deficit is unusually large when measured against the size of the economy. That is especially true for a time when the country isn’t facing a crisis such as a world war or a pandemic.
Bonds can be subject to the forces of supply and demand like anything else. If investors are satisfied with the amount of bonds they are holding, but are still offered more, that should drive down prices, pushing yields higher.
That could be risky for several reasons. Treasury yields reflect the cost of new borrowing for the U.S. government, which is seen as much less likely to default on its debt than any business or individual. As a result, rising yields push up borrowing costs broadly, whether it is a business issuing bonds or a family taking out a mortgage. Higher yields can also drag on stock prices by providing investors with a more appealing safe alternative.
Typically, changes in the outlook for government borrowing affect yields only on the margin. But there can be moments when they matter more.
In August, for example, a sharp selloff in Treasurys followed an increase in the Treasury Department’s quarterly borrowing estimates, which forced the government to boost the size of its bond auctions by more than investors had been anticipating.
That selloff raised alarms on Wall Street that the supply of Treasurys might be a bigger influence on yields going forward.
Ultimately, though, the yield on the 10-year note peaked at around 5% in late October. A subsequent rally in bonds got a boost when the Treasury surprised investors by increasing the size of its next round of auctions by a little less than they had expected. Economic data also softened, and by the end of the year, the 10-year yield was back below 3.9%.
The benefit of safety
Today, the 10-year yield is around 4.2%, while the total amount of outstanding Treasurys has topped $27 trillion.
How could investor demand keep up with so much supply?
One major reason: Treasurys still offer a reasonable return for basically no risk, as long as they are held to maturity.
Investors have alternative ways to earn a risk-free return. They can essentially lend to the Federal Reserve until the next day, getting paid an interest rate set by Fed officials at their regular policy meetings. They could do this for 10 years, continually rolling over their investment, and earning more when rates rise and less when rates fall. Or they could just lock in a return now by buying a 10-year Treasury note.
That generally keeps Treasury yields tethered to investors’ expectations for what short-term rates will average over the life of a bond. If an influx of new bonds pushed the 10-year Treasury yield above what investors could get by rolling over short-term loans, there would be a strong incentive for investors to choose the 10-year notes instead. That rush of demand would then drive their yields back lower again.
Indeed, the key short-term rate set by the Fed and the 10-year Treasury yield have exhibited a tight relationship over the past six decades.
It is impossible to know for sure how much the 10-year yield reflects forecasts for short-term interest rates versus other factors—such as supply and demand or concerns about unexpected inflation—that economists generally label as “term premium.”
But economists have devised models to try to provide an answer. One, created by New York Fed economists, currently shows that the 10-year term premium is slightly negative. The implication: If the supply of bonds is pushing up yields, it is being canceled out by other factors, such as investors wanting to buy Treasurys as a hedge against potential losses in stocks.
Foreign demand
Countries such as Germany and Japan also sell government bonds that investors consider ultrasafe. But Treasurys have additional attributes that make them especially attractive to global investors.
One big advantage is that Treasurys are easier to trade than other bonds. Size, in this case, is helpful. The huge volume of outstanding Treasurys means investors can easily buy large amounts of bonds of practically any maturity. They can also feel free selling their own holdings knowing that they can quickly find replacements.
Some $190 trillion of U.S. Treasurys were bought and sold in 2023, more than seven times the size of the market, according to Sifma, a securities industry trade group. Trading volume of German government bonds totaled roughly $7 trillion, just four times the amount of the bonds that were outstanding at the end of the year, according to Germany’s finance agency.
The liquidity of Treasurys is one reason why the dollar is known as the world’s reserve currency, according to analysts. Central banks and governments of other countries hold reserves for a variety of reasons, including managing the value of their own currency, but they favor the dollar in part because they can buy and sell Treasurys more easily than other government bonds.
“What I’ve sometimes said is that it’s not that the dollar is the dominant reserve currency, it’s that Treasurys are the world’s dominant reserve asset,” said Brad Setser, a senior fellow at the Council on Foreign Relations and former adviser to the U.S. Trade Representative.
Setser noted that the U.S. government’s large debt load looks more manageable when certain Treasurys are excluded, such as ultrashort-term debt that investors view as safe as cash, bonds held by the Fed, and those held by foreign central banks.
For decades, Treasurys have also generally offered higher yields than their peers—a result of broad economic and demographic trends and a lack of government borrowing in Germany. This has ensured steady demand from overseas buy-and-hold investors such as pension funds and life insurers.
The road ahead
Many investors and analysts remain at least a little concerned about the mounting supply of Treasurys.
Last year’s selloff served as a reminder that demand for Treasurys “is variable over time,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. “The worry is that investors are buying Treasurys today—that doesn’t mean they have to be buying tomorrow.”
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Still, Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets, said that, to a large degree, forecasted deficits may already be reflected in current bond yields.
“Issuance from Treasury is a very long, slow, secular thing that we have lots and lots and lots of time as markets to digest,” he said.
Write to Sam Goldfarb at sam.goldfarb@wsj.com
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Appeared in the July 17, 2024, print edition as 'Search for Safety Buoys Treasurys'.
