November 2024
The era of ultra-low bond yields of the 2010s are behind us as significant new investment must be financed while billions of existing debt needs to be refinanced too
While stock market investors celebrated after Donald Trump and the Republicans appeared on course for a clean sweep of government, the reaction in bond markets was less enthusiastic.
Whereas the S&P 500 index rose 2.5 per cent on the day after the election, the US long-term Treasury bond declined over 1.5 per cent. A growing sense of unease has emerged in the US bond market, as concerns about debt and deficits look set to become a major factor for investors.
The issue is that not only do large deficits add to the stock of debt but if bond yields increase, the cost of servicing the debt rises, risking a vicious cycle of rising debt levels.
Ever since the disastrous UK budget of 2022, people have asked could other economies suffer a “Liz Truss moment” with the bond market potentially spiralling. As the global safe haven asset off which other assets are priced, a big sell-off in the US Treasury market would have huge ramifications for global markets, potentially weighing on stock prices.
When the Federal Reserve cut rates 0.5 per cent in September, somewhat unusually, government bonds fell. Typically, bonds rise when the Fed starts to lower rates but this time signs of a renewed pick up in economic growth put upward pressure on yields. At the same time, Trump's improving poll numbers boosted confidence in the so-called “Trump trade” — bets that could benefit from a second Trump term.
While the specifics of Trump’s policies remain unclear, his platform includes lower taxes, deregulation, tariffs on foreign goods, and deportations. For markets, this implies stronger economic growth, larger deficits, and potentially higher inflation—all of which could push bond yields higher.
Only three years ago investors were still worried about the trillions of dollars in negative-yielding government debt.
A decade of sluggish growth, weak investment demand and bond purchase policies by central banks pushed yields to historic extremes. Covid-19 marked a turning point. Governments around the world abandoned their antipathy to deficit spending and rolled out trillions of dollars of supports.
Post-pandemic, the US has continued with significant industrial and infrastructure spending under Biden, leading to fiscal deficits of 6 per cent to 7 per cent, previously unheard of in an economy close to full employment.
Now, however, many in markets worry that we are nearing a tipping point for deficit spending and bond markets. The IMF recently warned that the US fiscal trajectory is unsustainable.
The dilemma for policymakers is that there is a long list of projects which require investment from the greening of the global economy, to industrial policy to defence in addition to existing pension and welfare commitments.
Mario Draghi’s recent recommendation to the European Commission highlighted a need for investment amounting to 4 per cent to 5 per cent of eurozone GDP per annum, a multiple of what was invested in the Marshall plan after World War II.
Efforts to square the circle have proven problematic. In the UK, Labour pledged higher investment, mainly funded through increased employer national insurance contributions, but gilt markets reacted negatively.
France has faced rising bond yields as it struggles to address a budget gap of 6 per cent of GDP. In Germany, disagreements over measures to cut the deficit led to a clash between the SPD and FDP, ultimately causing the government to fall.
While the risks may point to higher yields, an imminent crisis isn’t guaranteed. High debt and deficits alone do not necessarily spark a crisis—Japan is a case in point. Although a large projected deficit was the trigger for the UK gilt sell-off, it was heavily accentuated by derivatives selling in relation to pensions liability hedging, strategies which are less prevalent in other markets.
A key focus in the US will be whether Trump’s tax cuts are offset by spending cuts.
Although Trump should have the support of Congress, fiscal hawks in the Republican party may act as a moderating force in relation to unfunded tax cuts. Furthermore, hedge fund manager Scott Bessent, the current favourite to be Treasury Secretary, has proposed a “3-3-3” plan: reducing the deficit to 3 per cent, achieving 3 per cent economic growth, and adding 3 million barrels per day of oil production to keep oil prices low. If achieved, this would likely assuage bond market fears.
What seems clear is that the ultra-low bond yields of the 2010s are behind us. Not only must significant new investment be financed, but by some estimates, about $70 trillion in existing public and private sector debt needs to be refinanced annually.
This rising sea of debt could ultimately force central banks to reintroduce liquidity measures like quantitative easing — a factor contributing to this year’s gold rally.
For investors, periodic spikes in yields could provide tactical opportunities.
But when considering the possibility of a future debt crisis, it’s worth recalling economist Rudi Dornbusch’s famous line: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."
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