As the new tax bill makes strides, the prospect that a tidal wave of freshly issued government paper will slam bond prices has kept investors on edge.
That’s why analysts say Treasurys have experienced bursts of selling as an overhaul of the U.S. tax code makes headway through the chambers of Congress. The widespread belief that tax cuts — and, more important, their effect on budget deficits and public debt — are bearish for bonds helped the 10-year yield TMUBMUSD10Y, -0.12% briefly break above the 2.40% key level in October, which had capped the benchmark yield since May. Yields and debt prices move in opposite directions.
“Higher deficits [and] higher debt loads is not great for bonds, all else being equal,” said Mark Zandi, chief economist at Moody’s Analytics. “As a bond investor, I wouldn’t be all too excited about this.”
The logic goes that a fall in tax receipts would widen the federal deficit and push the government to issue more debt, weighing on the prices of Treasurys and driving up yields.
But higher borrowing costs have rarely materialized after past tax cuts, such as those delivered during the administrations of George W. Bush, Bill Clinton, and Ronald Reagan.
Tax cuts and tax hikes have had a fleeting impact on bond yields
“Deficits tend not to have as much as an impact on the bond market as people believe,” said Kathy Jones, senior fixed income strategist at the Schwab Center for Financial Research. “It’s not a big a driver, until it is.”
U.S. debt levels are far from the point where investors would have doubts about the country’s ability to pay its creditors, she added.
Other factors, of course, also influence the bond market. Expectations that stimulative economic policies would boost growth and inflation can also contribute to higher yields. The Trump administration and Republican lawmakers, meanwhile, argue that the planned tax cuts would pay for themselves by boosting growth, a claim disputed by many economists and budget watchers.
Most economists share the belief that a substantial rise in debt would ultimately push long-term yields higher. Using data going back to World War II, Zandi found that for every 1 percentage point increase to the debt-to-GDP ratio, the 10-year Treasury yield would rise by three to five basis points.
He said a $1.5 trillion estimated tax cut spread out over the next decade would therefore raise the national debt ratio by about 7% to 8% percent of GDP, adding as much as 40 basis points to the 10-year Treasury yield.
Even without the current tax bill, the Congressional Budget Office estimated that the annual budget deficit would widen to more than $1 trillion by 2022. As baby boomers retire and the population grows older, higher health-care costs and rising welfare payments are expected to drive up federal spending. If growth fails to keep up, that would send debt levels higher.
With deficits set to rise, the Treasury Department will crank up issuance to make up for the shortfall in tax receipts. The influx of fresh supply would create a buyer’s market, pressuring bond prices. Coupled with the impact of quantitative tightening as securities continue rolling off the Federal Reserve’s balance sheet, yields could rise much faster than expected with the central bank no longer serving as a large price-insensitive buyer to anchor demand.
“Treasury debt managers will need to increase auction sizes from one end of the yield curve to the other,” wrote Stephen Stanley, chief economist at Amherst Pierpoint, in a note.
David Ader, chief macro strategist for Informa Intelligence, said that as the government funnels more of its funds into maintaining its ever-growing interest payments, that would leave the economy with a smaller share of federal spending. At some point, he said, “that becomes an economic headwind.”
But he countered the Federal Reserve’s “ability to tighten is stronger than it is to ease.“ Though the central bank could crank up its benchmark rate or sell securities on its balance sheet outright, the Fed has limited scope to launch quantitative easing again or slash interest rates, which remain historically low after being pulled up from near zero in the Fed’s current tightening cycle.
Another factor keeping down interest rates has been the use of extraordinary monetary policy in the wake of the 2007-2009 recession, which helped depress yields for long-dated Treasurys even as public debt levels rose sharply. The Bank of Japan, the European Central Bank and the Federal Reserve now hold more than $14 trillion of securities on their portfolios after they launched asset-purchasing programs in a bid to push down longer term interest rates and stimulate their economies in the wake of the global financial crisis.
The combined balance sheets of the BOJ, the ECB and the Fed
Consequently, global investors searching for higher yields have crowded into the U.S. bond market, as Treasurys are one of the largest and most liquid assets in financial markets and offer a premium relative to many other developed market bonds. Though national debt levels remain worrisome, the U.S. situation is seen as comparatively better than other major sovereign debt markets like Japan.
“I don’t think the rest of the world looks that much better. We talk about the U.S. debt as if we’re in a vacuum. We’re not the ugliest dog in the show,” said Ader, arguing that concerns about a wave of outflows from foreign investors and central banks were overdone.
Those who argue quantitative tightening could offer the impetus needed to allow yields to lift off have discounted the impact of passive investing. He said forced buying from such price-insensitive market participants like debt-focused index funds could shore up the bond market, similar to a central bank’s asset buying.
Yet some feel this is all an exercise in speculation, and that it isn’t clear what the final impact of a growing U.S. debt load on government borrowing costs would ultimately look like, said George Goncalves, head of U.S. rates strategy for Nomura.
That uncertainty, however, is not stopping investors from playing it safe. Hedge funds and speculators have recently abandoned their bullishness on long-dated debt. Such investors slashed their net long positions on 10-year Treasurys, a measure of bullish bets, by 153,000 contracts for the week ending Nov. 3, the biggest drop in 2017.