A mismatch in demand and supply of US Treasuries is growing apace and could lead to increased lending rates regardless of central bank official rates. Such increases in the cost of borrowing, if they were to occur, could then slow economic activity unless the Federal Reserve takes further action.
How is this happening? As we went into 2020, the US economy had already begun to slow down – and indeed the global economy with it – due partly to a typical cycle, having experienced many good years prior, but also as a result of the de-globalisation brought about by the Trump administration. Then the virus took hold, adding further to the necessity to inject financial assistance to keep the economy on an even keel and mute what otherwise might have been significant swings in economic activity, jobs and growth.
Dealing with this current scenario is costly and expected to bring about a US fiscal deficit in the region of $4.7 trillion this year, not far off that seen in World War II, as the Treasury steps up its issuance of US government debt to fund it. An increasing proportion of that borrowing will come from longer-term debt, pushing government repayments well into the future for tax payers from the next generation to bear, just as was the case after the global financial crisis.
Meanwhile, the Federal Reserve, the US central bank, has sharply scaled back the pace of its asset purchases, from $75bn a day at the height of the pandemic in March to roughly $3bn a day now. At this rate the Federal Reserve will only be buying about 25% of the gross long-term Treasury supply between now and the end of the year, JPMorgan calculates.
Clearly this will leave the US Government looking for other investors to purchase their debt if they are to fund their ambitious, but perhaps necessary, plans. However, investing in a hugely indebted entity at rock bottom interest repayments is clearly not very attractive. Future issuance may not be fulfilled at rates the Treasury desires as it becomes forced to increase the returns it needs to pay to attract capital to its coffers. In the global financial crisis some governments changed their authorised pension scheme rules to increase liability matching, thereby forcing pension trustees to buy longer-dated bonds regardless of the risk / return dynamic, but such coercion tools are fewer now. The Federal Reserve could reduce the increased cost of lending by reducing its official rates again, potentially to negative territory (although they have said they would not entertain this idea given the European experience). Alternatively, it could step up its purchases of Treasuries to absorb the government’s issuance.
Nevertheless, fears that this ‘demand’ gap could cause yields to spiral higher, potentially upsetting still fragile financial markets, may not be as certain as would appear at first glance. As the uncertainty caused by tariffs and the virus continue, investors will likely continue to desire safe assets during the contraction in economic activity and consequential (short term perhaps but currently growing) deflationary risks. The lack of inflationary pressure now is evidenced by the 10-year break-even rate which remains at just over one per cent versus the Federal reserve’s target of 2%. This provides room for the Federal Reserve to reduce rates or step up its asset purchase programme in the short term at least.