Concerns over rising deficit and falling demand for US bond ‘overstated’

The concerns over rising US deficits, growing debt burdens and decreasing demand for US Treasuries are “somewhat overstated” as it is very unlikely that these factors will threaten US financial strength and lead to sustained high interest rates over time, according to Western Asset.

The fund manager’s product specialist, Robert Abad, said that whenever there was a selloff in bond markets, the government borrowing requirements were often pinpointed as a contributing factor but government deficits and borrowing needs were not a reliable predictor of bond strength or weakness.

“Consider the period going back to 2008: despite the global financial crisis (GFC) that year and the COVID-19 pandemic in 2020, which pushed deficit and debt levels to multi-decade highs, US interest rates continued to decline. At the moment, the financial markets are unnerved,” he said.

But the ongoing disputes in the US Congress, creating uncertainty about future spending, along with the significant rise in UST yields, are amplifying concerns about impending debt servicing costs.

“At present, the average interest rate on US public debt is 2.7%. According to the US Congressional Budget Office, this rate is expected to average 3.4% over the next 30 years, which is a significant factor behind the projected tripling of the deficit,” Abad added.

“However, we believe such long-term interest-rate projections should be taken with a grain of salt as economic conditions, political dynamics and policies can change over time.”

Abad said that long-term interest rates were heavily influenced by longer-term growth and inflation expectations and, additionally, they have moved higher since early August, due to short-term influences—both the anticipation of increased UST supply (issued to cover one-off expenditures and declining capital gains revenues from 2022) and a surprising shift in Fed rhetoric regarding 2024 policy rates.

“We would add that although monetary policy is already restrictive, there’s the possibility that the Fed may hike one more time in the near term. However, if recession fears suddenly resurface due to an unforeseen external shock, the possibility of imminent rate cuts would immediately be back on the table. It’s worth noting that over the past 30 years, the Fed has typically reduced rates approximately nine months after its last rate increase 2 in a tightening cycle,” he stressed.

Also, it was important to consider how long it might take for a higher level of interest rates to result in increased debt servicing costs, assuming rates remained elevated.

“In our view, the absence of price-agnostic UST buyers in today’s market doesn’t mean they won’t return—nor does this change imply a significant increase in the risk of the US encountering challenges in rolling over its debt or securing deficit financing, which are issues commonly faced by distressed emerging market (EM) countries.

“The US dollar’s status as the world’s reserve currency, facilitating easy borrowing for the US, and the recognition of USTs as the world’s safe-haven asset, especially in times of escalating geopolitical tensions, should dispel any doubts about the economic or financial resilience of the US.”

“In conclusion, the robust demand we’re currently seeing for shorter-dated securities, such as one-year US T-bills, makes sense. These securities carry limited duration risk and offer yields not witnessed since 2006. The message to investors seems to be clear: bonds are back, and better than before.”