The Bond Market vs. Increased Government Debt

The Congressional Budget Office projects that the federal deficit, over the next 10 years, will increase $1.6 trillion more than their earlier estimate of $10.1 trillion, mainly due to the recent passage of the Tax Cuts and Jobs Act of 2017.

 

 

 

 

 

 

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The Bond Market vs. Increased Government Debt

The Bond Market vs. Increased Government Debt

Will the Bond Market Choke on Increased Government Debt?

The Congressional Budget Office (CBO) projects that the federal deficit, over the next 10 years, will increase $1.6 trillion more than their earlier estimate of $10.1 trillion, mainly due to the recent passage of the Tax Cuts and Jobs Act of 2017. By 2027, federal debt held by the public is expected to equal nearly 100 percent of the nation’s GDP (more than twice the average of the last five years, and unseen since the end of WWII).1

These projections have left bond investors concerned that yawning federal deficits will spark inflation and that the sharp increase in the supply of Treasury securities would push rates higher. Supply is set to swell further due to the anticipated unwinding of the Federal Reserve (the Fed) balance sheet.

Do Deficits Impact Interest Rates?

In theory, the answer is “yes”; however, the reality casts some doubt that rising deficits necessarily send bond yields higher. For instance, since double-digit interest rates peaked in the early1980s, 10-year yields steadily declined, falling below 1.5 percent in 2016, despite a nearly uninterrupted string of federal deficits. Similarly, Japan’s interest rates sit at historical lows, even as accumulated debt has grown to 253 percent of its GDP.2

Nevertheless, yields ultimately are determined by supply and demand. As such, the impact of a greater supply on rates will depend upon whether the demand keeps pace or if the government needs to raise rates to entice buyers.

A Rising Demand for Bonds?

There are reasons to believe that the demand for bonds may jump in the years ahead:

  • Retirees—The retirement of Baby Boomers is expected to increase the demand for conservative, income-oriented investments.
  • Pension Funds—Pension funds look to use bonds to match future liabilities and, as workers retire, pensions may allocate more toward bonds.
  • Foreign Buyers—Overseas investors are a significant source of demand, though that demand may be somewhat hostage to the value of the U.S. dollar. A lower dollar may spark additional demand, albeit dollar weakness will negatively impact the value of current holdings by non-U.S. owners.

In the end, no one can be certain what higher deficits will mean for the bond market. The eventual outcome may even rest on how the Treasury chooses to fund that debt. Should the new federal debt be spread over the maturity spectrum, it could allow the markets to better digest the new supply. However, if the Treasury focuses new funding toward longer-term maturities, it may overwhelm current demand and require higher yields to attract enough investors.

Sources:

  1. https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/53651-outlook.pdf
  2. https://tradingeconomics.com/japan/government-debt-to-gdp

See referenced disclosure (2) (3) at http://blog.americanportfolios.com/disclosures/ 

About The Author

Cliff Walsh, CFA

 

Vice President of Asset Management 
631.439.4600 ext. 277 

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