By Paritosh Bansal
(Reuters) – The bond vigilantes’ backlash against spendthrift French politicians is an important reminder for the United States: The market will likely determine the tipping point for debt sustainability, and it will be difficult to predict.
In recent months, financial executives and investors have been increasingly attentive to rising U.S. budget deficits. But despite concerns on Wall Street, bond markets have been relatively upbeat on the issue, focusing instead on the Federal Reserve’s rate outlook, inflation and the economy.
Indeed, even though many of these people say that the debt will eventually prove problematic if it is not resolved, any calculation will be made in a few years, thanks to American economic strength and the enduring attractiveness of its markets .
The French experience, however, where concerns over fiscal plans have driven up yields, should serve as a cautionary tale about how the bond vigilantes who police government profligacy can suddenly awaken from their stupor. And the risk of such a situation happening in the United States in the coming months is increasing, with some expecting political prospects to start working their way into market calculations after the first debate between Joe Biden and Donald Trump later this week.
A senior financial sector official, alarmed by deficits in recent months, said the signal that debt had reached an inflection point could well be coming from the market.
That could come when investors start paying more attention to policy discussions between the two parties, which “will likely start shortly after the debate,” this person said.
One administration official said that while no one could predict when this would become a problem, he, too, had heard from market participants concerned about debt sustainability.
“There is no doubt that we face a debt and deficit sustainability challenge in the medium term,” the official said. But he added that President Biden has a plan to reduce deficits by $3 trillion in 10 years to get the situation under control.
The Trump campaign did not respond to a request for comment. The former president talked about cutting taxes, but also raising tariffs and reducing waste in the federal bureaucracy.
THE MARKET MOOD
A market surge can be problematic and have far-reaching consequences, especially if it persists. For example, investors expect the Fed to begin cutting rates later this year. If anything spooked bond investors about debt sustainability, yields would rise, undermining the central bank’s efforts to facilitate a soft landing for the economy.
In France earlier this month, market contractions following the decision to call early elections affected government financing plans and bank stocks. He was also blamed for the delay of sneaker maker Golden Goose’s IPO.
Certainly, the episode was less disastrous than the 2022 UK bond explosion, as my colleague argues that any sustained bet against French public debt can only be based on belief in the unlikely end of the euro. Any reaction in the United States would have similar counterbalances.
Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income, said any impact on markets would depend on investor sentiment at the time.
“The market is in a good mood right now,” Tipp said. “Everyone is convinced the Fed rates are going to come down and they want to maintain those yields for a long time.”
But he added that in a bearish environment, debt concerns could lead to a 40 to 80 basis point move in Treasury yields.
BLOATING DEFICITS
The scale of the problem is only growing. Last week, the Congressional Budget Office increased its cumulative deficit forecast for the 2025-2034 fiscal decade by $2.067 trillion from what it had projected in February.
Investors have been paying attention to this for a long time. PGIM’s Tipp pointed out the difference between the yield on 30-year Treasury bonds and an interest rate of the same tenor, called a SOFR swap, which also carries low credit risk like government bonds but is not affected by debt levels which increase the supply of Treasury bills.
In a sign that investors are charging more for the mountain of debt issued by the U.S. government, 30-year Treasury yields are now about 75 basis points higher than the SOFR swap.
Tipp explained that these gaps were inverted until the 2008 financial crisis, but reversed over the next decade as debt levels rapidly increased.
By comparison, yields on 10-year German government bonds are 14 basis points lower than the equivalent interest rate in Europe, known as the ESTR swap, partly reflecting Berlin’s better fiscal discipline.
I asked the industry executive what their conversations with other market participants were like. The executive requested anonymity to speak frankly without worrying about possible repercussions on the institutions with which he is affiliated.
If an investigation were to be carried out, the executive said, many would say that debt would become a problem in the next five years – a figure which could double over a 10-year horizon.
“There are those who say, ‘This is going to come back to bite us hard,'” the person said. “But no one has yet been rewarded for making that bet.”
(Reporting by Paritosh Bansal; editing by Anna Driver)
