PHILIP SHORT: Huge US government bond supply red flag for global financial markets

Monetary policy dominated the investment narrative for the past few years as economists, investors and consumers await the first interest rate cut. But  little attention has been paid to fiscal policy and the significant rise in the US government’s indebtedness since the Covid-19 pandemic.

But investors are beginning to take notice of the potential stresses and strains emerging in the government bond market due to a 60% increase to $35-trillion in the US Treasury market since end-2019. This is where government raises the funds it needs to meet its fiscal policy commitments. 

There is mounting concern that the supply of government bonds is likely to  outpace demand by far if government indebtedness increases as much as expected over the next years. Statistics show that the US Treasury expects to sell just short of $962bn in new Treasuries in the first half of 2024 and that government debt as a share of GDP is projected to rise to a record 120% in 2024 and to 200% in 2054, according to the US congressional budget office. 

Monetary and fiscal policy have a huge impact on the economy and financial market in the medium to long term. Generally speaking, when monetary and fiscal policies are simultaneously expansionary, markets will do well as credit is loosened and governments are spending. The more challenging environment is when they are moving in opposite directions, which brings us to the present period, from April 2022 to now, when the US central bank is keeping a tight rein on monetary policy while the government continues to spend before elections in November.

The first chart shows that the Fed started raising rates in early 2022 in an effort to curb growing inflation. Countering this, in the chart below, is the Treasury’s response in issuing a significant amount of debt, now nearly $35-trillion. This raises the question, why is the Treasury issuing so much debt when the economy is strong (quarters three and four of 2023 GDP growing 4.9% and 3% respectively) and unemployment so low? This should be a time to save, run a surplus and pay off debt. 

Many believe that as this is an election year in the US, the Treasury is keeping the economy running hot, unemployment low and the populace generally happy to get the administration re-elected. The Treasury ramped up debt issuance in 2023, issuing more than $2.5-trillion debt in that year alone. For a country that receives $6-trillion a year in total tax receipts, that’s a big number.

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Worryingly, that $2.5-trillion in debt translated to only $1.5-trillion in GDP. Historically, the GDP multiplier from debt is one to three times, meaning every dollar of debt raised by the US government should translate to $1-$3 in GDP. In this case the multiplier is a fraction at 0.6 times, implying a weaker private sector. One can argue there is a time lag from borrowing to generate GDP, but the increasing debt to GDP illustrates that debt is outgrowing GDP over the long term as well.

When thinking about a country issuing debt in relation to GDP, it helps to think of the country as if it were a business: if business owners borrow $100,000 from a bank to invest in their business, they would expect that investment to generate a return of at least $100,000 plus interest on the borrowing to pay back to the bank.

Same with a country: the GDP will translate into tax revenue, which will be used to pay back the debt. That GDP cannot keep up with debt issuance is something to watch. That the US debt to GDP ratio is more than 120% is a cause for concern, and that it is projected to hit 200% in 30 years is a red flag. 

The problem markets are trying to decipher is: which way does the balance of financial thrust, monetary or fiscal, take us? Fed chair Jerome Powell is trying hard to limit inflation and cool the economy by hiking interest rates. Treasury secretary Janet Yellen is trying to stimulate the economy by pumping money into it, increasing spending on things such as infrastructure and employment. This spend is one of the reasons inflation stopped dropping in the first quarter and is causing concern for inflation in future.

The breakeven inflation rate is the spread between the Treasury yield and the yield on inflation-protected Treasury bonds — what the bond market is now pricing or expecting inflation to be in one year. The graph shows that in early 2024 inflation expectations were about 2%. Three months later that has now jumped to 4%, a sharp, meaningful incline.

The Fed’s inflation target is 2%. Now there are some sectors of the underlying economy that are struggling from higher interest rates, even with the flash spending by the Treasury. The dilemma is that the Fed cannot cut interest rates too soon or it will reignite inflation. If actual inflation does begin to reaccelerate, the consequences will be dire.

Fiscal policy and government spending is unlikely to be constrained soon and the Fed is clearly committed to maintaining its hawkish monetary policy stance as long as inflation is above target. The economy thus runs the risk of being weighed down by high, rising government debt and the adverse impact of high interest rates on consumers and the private sector’s spending power.

• Short is fund manager at Flagship Asset Management.