The bond market's warning
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The multitrillion-dollar bond market is sending a message to President-elect Trump and the new Congress: There is no fiscal free lunch to be had.
Why it matters: A surge in longer-term borrowing costs over the last couple of months may reflect deepening concern about high fiscal deficits among global investors who buy U.S. government debt.
- Regardless of the cause, it implies that as Republicans seek to extend Trump's tax cuts beyond this year, markets will pressure them to find spending cuts or other deficit-reducing offsets.
Driving the news: The yield on 10-year U.S. Treasury notes reached 4.71% Wednesday morning, up from 3.62% in mid-September.
- Bloomberg cites evidence from futures markets that traders are positioning themselves for protection if rates were to rise further, to north of 5%.
The intrigue: This upward shift in longer-term rates has come despite a full percentage point of Fed interest rate cuts since September — with most Fed officials expecting a couple more rate cuts this year.
- It is a reminder that while the Fed controls short-term interest rates, longer-term rates are set in the bond market based on the outlook for inflation, growth, deficits and more.
- The details of why long-term rates are on the rise are important. This surge in rates has mostly not been driven by a changing inflation outlook, at least based on the relative prices of inflation-protected bonds.
- What appears to be happening is a rise in the "term premium," the compensation investors demand for the risk of buying longer-term debt.
State of play: It is impossible to know for sure why the term premium moves as it does, and technical factors around supply and demand for bonds are likely in play. But investor wariness of looming deficits is a textbook reason.
- Asked about the rise in yields at an event in Paris this morning, Fed governor Christopher Waller noted "more and more attention, concern about fiscal deficits."
- Waller also affirmed that he expects further Fed rate cuts to be justified this year, and said he doesn't expect tariffs to have a "significant or persistent effect on inflation."
What they're saying: "The market is telling us something, and it is very important for investors to have a view on why long rates are going up when the Fed is cutting," writes Apollo's Torsten Slok, noting it is a "highly unusual" situation.
Between the lines: Regardless of exactly why yields have surged, the fact that they have points to a very different macroeconomic environment than the nation faced eight years ago, when Republicans passed sweeping tax cuts in the first Trump term.
- In January 2017, the 10-year yield was a mere 2.4%.
- Borrowing costs are now meaningfully higher than forecast in the Congressional Budget Office's most recent projections. CBO's June budget forecasts assumed the 10-year yield would be 4.1% in 2025 and lower thereafter.
The bottom line: With rates higher, any given deficit-expanding policy will come at a higher cost — in terms of interest expense and higher rates — than it did when Trump was last in the Oval Office.
