So, the Fed is staying where it is for now. Today (Wednesday) there was a unanimous vote to keep rates where they are, the first time it passed on a rate increase for two consecutive meetings since the current cycle of increases began.
Officials have been trying to balance two risks. They don’t want to overdo rate rises to avoid causing an unnecessarily severe downturn. They also don’t want to allow inflation to reaccelerate or to settle at levels well above their 2% target. “Those risks are closer to being in balance,” Powell said.
The big questions for the Fed center on what officials are looking to see in the economy, and what it would take for them to conclude they are moving in the right or wrong direction. A continued slowdown in inflation could allow them to continue holding rates steady, while any acceleration in price pressures could lead them to hike again.
Wait and see for now then.
As at the time of writing, the ten-year now yields 4.81 percent, back below the magic (and magically arbitrary) 5 percent level.
As Stephen Miran argued in a recent piece for Capital Matters, part of the reason for the most recent surge in rates was simple supply and demand:
In the months before the debt limit was lifted via the Fiscal Responsibility Act of 2023, debt issuance was on pause while Treasury was unable to borrow more than the statutory limit. While issuance was on pause, the accumulating deficit and inability to borrow created a pent up need to tap markets for funds when the debt limit was lifted. When it resumed issuance, Treasury had to borrow not only for normal government operations, but also to refill all the government’s savings accounts it had drained to avoid default, a result of the debt-limit standoff.
Then, in early August, Treasury announced it was going to begin rolling the bills it had issued into longer term bonds, meaning that there would be an increase in the number of bonds made available to the market.
As we know, prices are a function of supply and demand, and Treasury announced a supply bonanza. The natural economic response was to push prices down. Since yields and prices move in opposite directions, yields started moving higher.
The Treasury Department saw the market response and keen, presumably, to push rates down a bit, has taken note.
The Treasury said on Wednesday that it would continue to increase issuance of shorter-dated notes at the pace it set three months ago, while slowing the pace of 10- and 30-year bond issues…
“Bond markets like it — the estimate had been for $114bn but we are only getting $112bn, and in a fiscal world with little to cheer about, that’ll do,” said Jim Leaviss, chief investment officer of public fixed income at M&G Investments.
In a separate announcement on Monday, the Treasury said it expected to borrow $776bn in the period between October and December, less than the $852bn initially forecast, and lower than the $1tn borrowed in the previous quarter. The Treasury attributed the lower borrowing needs to “higher outlays”, suggesting higher tax income.
But note Leaviss’s comment about there being little in the fiscal world to cheer about, a reference to the U.S.’s longer-term fiscal, uh, issues.
This echoes a point made by Miran too:
Deficits exceeding 7 percent of gross domestic product during peacetime and outside of a severe recession are as shocking as they are fiscally irresponsible; they further suggest deficits will exceed 10 percent of GDP if we have a mild economic downturn or get drawn into a hot war.
The Congressional Budget Office estimates that, by mid-century, interest payments on our mountains of debt will eat up 35 percent of tax revenues. But those estimates rely on interest rates near 4 percent. If interest rates stay near 5 percent, we would need closer to 50 percent of tax revenues to pay for old and new debts, leaving less revenue available for government functions like defense.
Meanwhile, British economist Tim Congdon runs the numbers and doesn’t like what he sees coming our way:
The so-called “structural” deficit — the deficit on a cyclically-adjusted basis — runs at about 9% of gross domestic product, according to the International Monetary Fund. Yes, according to the IMF . . . . [T]he IMF revised upwards its assessment of the 2023 structural deficit by 2% of GDP in the six months between the April and October issues of its World Economic Outlook. The IMF is not in the business of frightening the horses, but it projects the structural deficit still to be 7% of GDP in 2028. The ratio of gross US government debt to GDP by then will be heading towards 140%, somewhat higher than has been typical for Italy in recent decades. . . .
The question of sustainability has to be raised. The danger here is that a loss of market confidence will alienate potential buyers of US Treasuries, who then need a higher prospective return to compensate them for the risks. (Another point here is the USA’s suspension/freezing of Russian holdings of US Treasuries. It is fully justified under international law, because of Russia’s invasion of the Ukraine. But holders of US Treasuries around the world — including the Chinese government — may have been surprised by it.)
“Surprised” is a diplomatic way of putting it.
In a Capital Letter from March 2022, shortly after Russia launched its full-scale invasion of Ukraine, I considered the impact of the financial sanctions imposed on Moscow, which included, of course, the suspension/freezing of Russia’s holdings of Treasuries referred to by Congdon, and noted that this came with costs to the U.S. These might include an erosion of “the almost universal acceptance of the dollar as a store of value,” something not to be wished for:
That the greenback is the reserve currency is one of the foundations of American power (not least because of the way that it allows this country to finance itself). But the more that the U.S. uses the dollar as a weapon, the more (over time) it will undermine the willingness of others to put their faith in it, with consequences that, to say the least, could be self-defeating.
By extension, reduced trust in the dollar implies reduced trust in Treasuries. For now, this is only a factor at the margin, but as we look further into the future, it could start to matter, especially as an anti-American bloc led by Beijing (still the second largest foreign holder of treasuries) continues to solidify.
Back to Congdon:
As the yield rises to persuade more nervous investors, the servicing cost of the debt increases. In a vicious spiral, the extra servicing costs add to the deficits and boost the growth rate of future debt…Federal debt interest payments…reached 5% of GDP at the end of the Reagan Presidency, due – above all – to the supply-sider tax cuts of those years. A plausible view is that – with the gross-debt-to-GDP ratio moving to much higher levels in the late 2020s than under Reagan – the ratio could climb to 6% or 7% of GDP.
Neil Irwin at Axios adds another twist of the knife, citing the latest report by the Borrowing Advisory Committee, which is made up of 15 large financial firms active in the Treasuries’ market. According to its authors, “[d]emand for US Treasuries may have softened among several traditional buyers.” This is, writes Irwin, all part of a “recent shift to more price sensitive investors” for Treasury bonds.
If nothing else, this is a reminder that the holiday from reality represented by the era of ultra-low interest rates is over. The consequences will not be pretty.