Rising Treasury Debt Fuels Rising Yields despite Washington Negotiations

The good news: Officials in Washington were able to avoid a federal government shutdown. The bad news: The stopgap measure reached in the late hours of the showdown between Republicans and Democrats only kicked the can down the road by a mere 48 days. While raising the debt ceiling has become a known point of contention in recent years, this time it coincides with a surprisingly hawkish sentiment from the Fed that is poised to keep rates higher for a prolonged period. This is significantly increasing the cost of government borrowing.?

While the federal government’s balance sheet has ballooned to a record $33 trillion, the lower rate environment of the last decade has eased fears of a problematic fiscal scenario, at least until now. After lying dormant for a few months following a deal in late May to lift the debt ceiling into 2025, the market’s focus is back on the bloated size of the fiscal balance sheet, resulting in the eye-opening notion for investors that governments cannot spend unchecked, and at some point, debts do need to be repaid.

The Elephant in the Room

Over the past 10 years, U.S government debt has grown by 98% to over $33 trillion, more than 1.2 times the size of the domestic economy. Already bloated at $5.7 trillion in 2000, policies implemented to combat recessionary cycles, the financial crisis, and a forced economic shutdown, not to mention accommodative tax cuts and involvement in international conflict, led to the fastest expansion of the government’s balance sheet on record. As a result, many fear the U.S. is headed for a “debt trap” whereby growth is tamped down as funds are diverted away from investment to cover the higher costs of servicing existing debt. In other words, debt begets more debt.?

Others, however, are less concerned about the country’s mounting obligations, pointing out that the cost of financing the debt – in terms of interest payments relative to GDP – has been relatively low, at least over the past two decades. Now, however, with the Fed raising rates at the fastest pace since the 1980s and increasing the risk of a downturn, if not outright recession, it may be an appropriate time to turn off the spending spigot.?

The Debt Saga

The debt ceiling, which historically was a point of procedure, has in recent years become a game of political gambling, or a chip to be bargained with. Used by both sides of the political aisle, the debt ceiling is often held hostage in order to gain advantage for other fiscal agenda items.?

This time, the showdown was largely led by House Republicans who appeared more than willing to risk a government shutdown to have demands of lower government spending met. While in the near term, a government shutdown could result in a loss of access to many federal functions and a temporary suspension in paychecks, fiscal conservatives often see the debt ceiling as their only option to arrest further debt accumulation and avert a larger economic catastrophe in the future.?

With less than three hours left, officials in Washington were able to reach an agreement and avoid a government shutdown. The bipartisan measure, however, will only keep the U.S. government funded until November 17, far from a lasting solution to either the debt ceiling debate or the broader issue of unruly fiscal outlays. Negotiations are already underway for further spending provisions with additional aid for Ukraine in particular conspicuously excluded from the latest deal. President Biden urged Congress to offer continued funding for Ukraine in order to?“defend themselves against aggression and brutality”?and further invasion by Russia, while conservatives have been clear any further?international?security aid?must be tied to?domestic?security funding for the U.S. border.?

Investors Take Notice

While common sense often indicates that spending beyond one’s means is unsustainable, the market has largely ignored the notion of the country’s potential fiscal woes. Not only historically, as the government balance sheet has quadrupled in the last 20 years, but also more recently as well. Despite unprecedented fiscal stimulus to the tune of $6 trillion dollars dispensed during the pandemic and the Fed’s overly transparent commitment to higher rates in a quest to reinstate price stability, investors are still consistently calling for a series of rate cuts, potentially returning the cost of funds back down to historically accommodative levels. This forecast for a reduced cost of capital and by extension expectations for a deflated impact on debt servicing costs seemingly kept concerns over the U.S. government’s finances in check.

The latest round in the debt ceiling saga, however, coupled with a sizable increase in U.S. Treasury debt issuance as well as ongoing hawkish commentary from Fed officials and a more aggressive FOMC forecast perpetuating the notion of higher for longer, has finally given just cause for concern as the outlook for the budget deficit worsens. In Q3, the U.S. Treasury boosted the size of its quarterly bond sales for the first time in 2 1/2 years to $1 trillion, nearly 25% more than earlier estimates, a step-up that is expected to extend into 2024 and beyond. This contributed to the recent selloff in Treasuries.?

Repricing of Risk

As the government’s balance sheet reaches a record level, the Fed’s commitment to ongoing restrictive policy suggests the chickens may finally have come home to roost, resulting in a sizable repricing of longer-term risk. Yields on longer-dated securities rose to the highest level since 2007, with the 10-year hitting 4.88% and the 30-year topping 5.00% this week. With shorter rates following along with the Fed, the sizable move in the longer end of the curve has reduced the curve inversion – 2s to 10s – from -108bps to -26bps, the least since October 2022.

Investors previously turning a blind eye, appear to be increasingly aware of the mounting repercussions of a heavy debt burden coupled with higher interest rates and an uncertain economic outlook. That’s not to say investors won’t resort to old notions of grandeur, but with some Street forecasts already calling for 5% on the 10-year, at the very least the complacency of the last two+ years is under threat.

-Lindsey Piegza, Ph.D., Chief Economist

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