This article first appeared in Forum, The Edge Malaysia Weekly on November 6, 2023 - November 12, 2023

In 1993, when Bill Clinton became US president, he was warned by his treasury secretary Robert Rubin that free fiscal spending would be stopped by the US bond market. Clinton’s political adviser James Carville famously joked that he would like to be reincarnated as the bond market, because “you can intimidate anybody”.

Recently, JPMorgan Chase CEO Jamie Dimon offered his succinct take on the US economy. He said: “Currently, US consumers and businesses generally remain healthy, although consumers are spending down their excess cash buffers. However, persistently tight labour markets as well as extremely high government debt levels with the largest peacetime fiscal deficits ever are increasing the risks that inflation remains elevated and that interest rates rise further from here. Additionally, we still do not know the longer-term consequences of quantitative tightening, which reduces liquidity in the system at a time when market-making capabilities are increasingly limited by regulations.”

In recent weeks, the US Treasury market volatility has been higher than that of gold, the other store-of-value benchmark. What is going on?

The US Treasury yield curve has been inverted since July last year, foreshadowing a recession. The steeper the inversion, the deeper the recession, because lower long-term interest rates signal lower future growth. However, the yield differential between two-year and 10-year Treasury bonds has become compressed from 53 basis points (bps) as at end-2022 to 15bps currently, suggesting that inflation may stay higher for longer and the recession may be mild.

This corresponds to data from the CME FedWatch Tool that calculates future interest rate probabilities. By mid-2024, the median expectation is split between the US Federal Reserve holding interest rates at the current level of 5.25% to 5.50%, or lowering them by 25bps. By December 2024, traders believe there is a 95% probability that rates will be lower than where they are now.

When yields increase, bond prices fall. The largest exchange-traded fund for bonds, the iShares 20+ Year Treasury Bond ETF, has shed 13% of its value from the start of the year. In contrast, the US stock market has performed remarkably well, rising nearly 10% in the same period, propelled by extraordinary gains in mega cap tech stocks. The positive sentiment towards equities partly reflects strong US GDP growth which was 4.9% in the third quarter, outpacing inflation. Unemployment has remained low at 3.8%.

However, US inflation has averaged about 3.5% in the period, which means that real interest rates (nominal rate minus inflation) have risen above 1% per annum and is beginning to bite on real economy activity through the cost and balance sheet effects. As US deficit spending reached US$2 trillion or 7.5% of GDP in the fiscal year ending September 2023, double last year’s level, the bond market is acting again as a “fiscal vigilante”, demanding higher yields to punish fiscal laxity.

The US bond market is a confluence of factors representing the demand for funds by the US Treasury and supply of funds by the market, augmented by whether the Fed is loosening or tightening. The US Treasury Department completed its auction of new two-year Treasury bonds last week, announcing that it may borrow another US$776 billion in the fourth quarter, followed by US$816 billion in 1Q2024. There is currently about US$33.2 trillion of US government debt or 123% of GDP that needs to be refinanced at higher interest rates. Analysts expect US$5 trillion to US$7.6 trillion of that debt to mature within a year.

The average interest expense borne by the US government is just shy of 3% per annum, owing to long-term debt raised during the period of near-zero interest rates. For most of the quantitative easing (QE) era, the US government’s interest servicing cost was between 2% and 3%, compared to costs of nearly 5% in the pre-QE era. The difference this time is scale. US debt has more than doubled from US$14.1 trillion at end-2008, so every percentage point rise in interest rate would eventually increase interest expense by over US$330 billion per annum, roughly 1.3% of GDP. And the debt is still growing.

The US can continue funding the fiscal deficit by sucking up global savings as long as the rest of the world is happy to receive higher interest rates on US dollar debt in the short term. But will these countries continue to do so without higher compensation over the longer term?

Japan has a similar domestic debt problem, but not an international one because she is a net lender to the world. The country has amassed a debt-to-GDP ratio of 264% after decades of zero interest rates and ran a fiscal deficit above 6% of GDP. But low interest rates also drove Japanese savings abroad, particularly into US Treasuries. What if this flow reverses?

Global inflation has presented the Bank of Japan with a conundrum because domestic prices have risen too. Japanese investors exposed to negative real rates face asset price deflation amid higher yields (US and Japanese bond prices would head lower), while the weak yen is letting in inflation via imports. The Bank of Japan is wary of upsetting global markets through rapid policy changes, so it has reacted by steadfastly holding on to the status quo, allowing small flexibility for 10-year bonds to have a 1% yield ceiling. This caution also reflects concerns about the fiscal burden, since Japan’s Ministry of Finance has estimated that a 1% increase in interest rate would add ¥3.7 trillion to government interest payments three years later (which is about 0.6% of GDP).

There are three ways to reduce an unsustainable debt burden. The first is very painful, by requiring fiscal austerity or spending cuts. The second is to allow the debt to be inflated away, by letting inflation rise faster than the domestic interest rate, but this approach is usually politically unacceptable. The final way is to achieve productivity gains and use the growth in wealth to pay for the debt. While ideal, few governments have achieved the last option, because it often requires deep structural reforms to be made before productivity gains can be achieved. The nightmare is to be trapped in a vicious cycle of higher interest rates, lower growth, spurring higher levels of fiscal deficits and debt.

Therefore, higher bond yields “regulate” unsustainable fiscal practices. There are no easy ways to cut debt addiction. Famed bond trader Bill Gross has predicted a recession in the fourth quarter, citing regional bank troubles and a spike in auto delinquencies as telltale signs. Right now, marginal borrowers with poor creditworthiness are being asked to pay usurious interest rates of 11.72% to 21.38% to secure car loans in the US.

So far, markets continue to hope for a soft landing, but the central bank toolbox may not be enough to guarantee it. Ned Davis Research produced a chart that showed remarkable similarities between the current inflation trajectory and the 1970s stagflation era. Historians remember that the US was hit by an energy crisis following the 1973 Yom Kippur War, when the Middle East inflicted an oil embargo upon the US in retaliation for American support of Israel, heralding a period of stubbornly high inflation. Higher geopolitical volatility implies that the market should be compensated with higher risk premia.

These risks are made worse by unscrupulous politicians pursuing narrow agendas. For example, House Republicans in the US recently tabled an emergency aid bill to Israel to be funded entirely through budgetary cuts aimed to maim the tax department. These irresponsible acts are all made with the 2024 US elections in mind. In fact, over 50 countries are scheduled to hold elections in 2024, including geopolitically sensitive nations such as Russia, Ukraine and Taiwan, which adds to the overall market uncertainty.

In short, higher risks are being reflected in higher interest rates, but then create more debt burden around the world. As Dimon sagely warned, “This may be the most dangerous time the world has seen in decades.”

Tan Sri Andrew Sheng writes on global issues that affect investors. Tan Yi Kai is a Malaysian multi-asset trader based in Hong Kong.

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