“You shouldn’t see volatility in the bond market. When you see it, it commands attention.” So warned Joe Brusuelas, chief economist at RSM, when asked about what’s behind the bond market rout and how bad it could get.
Treasury volatility jumped in October according to the CME Group Volatility Index (CVOL), which measures market expectations for 30-day forward implied volatility. The index recently reached a level of nearly 140, its highest level since March.
The structural shift toward higher yields began five years ago but is now accelerating amid persistently high inflation and growing fiscal deficits, added the middle-market researcher's lead economist.
Consequently, risk dynamics are being repriced across the fixed-income complex, notably for 10 and 30 year notes, triggering a bond selloff in October.
Brusuelas sees things getting worse as the U.S. is expected to issue additional debt to finance economic expansion and defense outlays.
“The U.S. will run at around 5% to 6% deficits,” he said. “When you have that and persistent inflation, the repricing of risk will move yields much higher.”
Recent RSM research shows that much higher rates will likely be needed to manage inflation. In one model, the team looked at how yields ranging from 4.5% to 5.5% – and all the way to 6% – would impact inflation. Even at the highest level, the analysis found that while economic growth and employment slowed somewhat, inflation didn’t budge.
“This told us the U.S. market is underpricing the risk of more robust inflation and the Fed is underestimating what they will have to do to ensure price stability,” noted Brusuelas.
Rising Debt Payments
The bond selloff is also happening in other G7 countries running high deficits, most notably France, whose difficulties are triggering worries of a European bond crisis.
The heightened risks come as net Treasury issuance is set to rise over 40% to roughly $1.2 trillion in the fiscal year ending September 30, according to BondSavvy’s Founder and President Steve Shaw. Next year’s issuance could be similarly robust as government spending continues to increase, lifting the national debt to well over $40 trillion.
Growing interest expenses are more concerning, however, as a large number of notes issued at extremely low rates during the pandemic are scheduled for refinancing.
“There is a significant amount of debt maturing in the next two years with coupons near zero,” Shaw said. “While the government is issuing more notes at the shorter-end of the curve [like 1s, 2s or 5s] to pay lower rates [and interest], replacing older bonds with materially higher coupons will raise debt expenses.”
In October, the 10-year yield reached 5.36% (its highest level since 2002) and the 30-year yield reached over 5.7%.
Amid this backdrop, observers said recent auctions have not gone as well as expected, while large buybacks in August aimed at calming the market also saw underwhelming demand. The top buyers of U.S. paper, such as Japan and China, have also been trimming their purchases, signaling foreign investors’ concerns about the growing fiscal deficit, stubborn inflation and geopolitical uncertainty.
The pullback could worsen, billionaire investor Ray Dalio told Bloomberg News.
“The Chinese don’t want to continue to accumulate,” he said, adding that economic issues are weighing on top of geopolitical ones. Japan, he noted, has lent “a lot of money” and is looking to recover it.
In July, Japan saw a $12.8 billion drop in its holdings to $1.1 trillion. As of the same month, China had gradually lowered its holdings to around $618 billion, down from a $1.3 trillion peak in 2013, according to the financial newswire.
With the Federal Reserve seemingly maintaining a higher-for-longer policy stance and markets pricing additional tightening according to CME FedWatch, foreign appetite for higher coupons may rise (as it has during past tightening cycles), boosting demand for Treasury notes.
However, Brusuelas said this trend may weaken in the near term and that he will carefully monitor upcoming issuance to see how it holds.
An Unsustainable Path?
Treasury Secretary Scott Bessent has moved to address fears about a potential U.S. debt crisis, which Dalio said could happen within three years.
During a Pennsylvania Chamber of Business event, he said a mix of spending restraints will start to alter the path of U.S. government borrowing and that the government will start “bending the curve” of higher yields.
Oliver Allen, senior U.S. economist at Pantheon Macroeconomics, said Washington has plenty of ways to tackle its debt problem, which he noted has not yet become critical.
“It can cut spending or tap on its cash reserves,” he said, adding that additional issuance at the shorter-end of the curve can help reduce interest expenses.
As of late October, 1-year and 5-year debentures pay roughly 4.10% to 4.40% and 4.82% to 4.94% respectively compared to the near 5%+ rate of the 10- and 30- year.
The Treasury must take every opportunity to refinance government liabilities at the lowest possible rate, Allen said, adding that it missed a chance to do so during Covid-19.
“During the pandemic, Janet Yellen [former Treasury Secretary] refinanced a bunch of short-term T-bills at a very low rate but should have refinanced the long bonds as well as that would have lowered overall payments. Now the government needs to rollover those bonds at a much higher expense.”
Still, the U.S.’s fiscal position is not yet unsustainable – but “on an unsustainable path,” Allen continued.
“When you take the fiscal deficit and the amount of debt and interest that has to be paid and zoom out a couple of decades, it all starts to look pretty ugly,” he said. “But the government has time to cut spending and benchmark rates before D-Day hits. So when you look at the rise of yields today, it’s not a fiscal panic. It’s more a reflection that economic growth is high and that interest rates and yields should be higher as a result.”
Future Demand and AI
Ethan Heisler, editor in chief of the Bond Industry Letter, said investors will continue to buy U.S. bonds as the country remains the world’s largest and most trusted issuer.
“We are the fiat currency of the world, so how much we want to print is what we are going to print and you are going to love it,” he said.
The U.S.’s attractiveness compared to other sovereign borrowers means it still has room to issue debt.
“If my competition is China, Japan, the UK, the EU, Canada or Australia, I have nothing to worry about,” added Heisler. The U.S. accounts for around 26% of global GDP.
But there's growing competition, said Allison Schrager, a senior fellow at the Manhattan Institute, contradicting that view. Europe, for instance, is issuing a lot of debt, including from highly-rated corporations, and this could add pressure on future U.S. issuance, she noted.
On the opposite end of the spectrum, Schrager said government paper could benefit if the AI bubble worsens, possibly leading to potential defaults from AI builders or hyperscalers.
“Some hyperscalers are more highly rated than Treasuries,” she said. “So if they were to default, that would generate demand for government bonds.”
Bond Futures
To help investors manage risks around Treasuries, CME Group offers a range of futures and options to help hedge the entire yield curve. During the third quarter, U.S. Treasury futures and options average daily volume increased 25% to 9.4 million contracts.
To provide participants with additional trading opportunities, the derivatives exchange is set to launch Treasury Link, a product that will enable investors to trade the spread or price gap between Treasury futures and cash Treasuries in a centralized, single market.
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