Are rising US budget deficits causing Treasury yields to climb?

Published on09 MAY 2024

Large US federal budget deficits are creating concerns about whether there’s enough demand for Treasury bonds.

For now, while there are few signs that Washington will cut deficits anytime soon, there appears to be enough investor demand for the sheer amount of Treasury debt, according to Jonny Fine of Goldman Sachs Global Banking & Markets and Alec Phillips of Goldman Sachs Research, who discussed the topic on an episode of the Goldman Sachs Exchanges podcast.

The US federal budget deficit is estimated to rise to $1.7 trillion this year from $1.375 trillion in 2022, according to Goldman Sachs Research. In order to fund rising deficits, the US Treasury department has to issue more debt, “so we’re seeing these very, very large amounts having to clear through the market,” says Fine, head of Global Investment Grade within the Financing Group. “The main concern is: Where’s the demand coming from to satisfy all of this supply?”

Fine adds that as a corollary to this, some wonder whether “the yield curve needs to reprice in order to effectively accommodate the issuance needs of Treasury.” In other words, will Treasury bond prices have to fall (and yields rise) in order to entice investors to buy yet more bonds?

Yields have indeed risen substantially this year. But Fine clarifies that this is much more about Federal Reserve policy than it is about a growing supply of Treasury debt. Bond yields are reacting to burgeoning expectations that rates set by the US central bank will be relatively higher for longer.

As far as the climate in Washington, Chief US Political Economist Phillips says few politicians seem committed to curtailing deficits, which he finds unsurprising given the low level of voter focus on the issue. Interestingly, Phillips says that whether government is divided or not could have a more significant on the deficit than the winner of the presidential election.

Major fiscal legislation typically passes when one party controls everything — the House, the Senate, and the White House, Phillips says. “In the case of an all-Republican scenario, that probably means extending all of the expiring tax cuts plus probably a little bit more on top of that,” he says. A Democrat-controlled Washington will likely increase spending.

A divided government, on the other hand, may struggle to pass major legislation. “It just becomes very difficult to do very much,” Phillips says. “And because you have some fiscal restraint built into the law – tax cuts are set to expire, you have spending caps in place, etc. – doing nothing actually, surprisingly, probably results in a slightly smaller deficit than the other scenarios.”

Taking the longer view, Phillips observes that the bulk of US debt has been added during recessions, which is part of what makes recent deficit spending so unusual. “I think the big question for the fiscal side ultimately is: When does the next recession occur, and what is the fiscal response to that?”

From a market perspective, Fine predicts that “we'll get moments in time where people will be concerned about deficit financing and Treasury issuance.” He adds that poor demand at a Treasury auction (in which investors, banks, and brokerages submit bids to the government for Treasury securities) could precipitate “a selloff and a lot of headlines.” But he says this will likely be “a bump in the road” for markets, rather than the cause of a major correction.

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