Here’s why some bond traders care so much about the US government’s budget deficit

Press Room

1 year ago

A version of this story first appeared in CNN Business’ Before the Bell newsletter. Not a subscriber? You can sign up right here. You can listen to an audio version of the newsletter by clicking the same link.

It’s no secret that the US government has amassed trillions in debt over the past few decades. The national debt currently stands at more than $33 trillion, according to the Treasury Department, and there aren’t any signs that debt could meaningfully shrink anytime soon.

And as the mountain of debt keeps piling up, and the government’s budget deficit remains massive, some bond traders are now joining politicians in decrying the government’s ever-growing financial obligation.

They’re known as “bond vigilantes,” fixed-income traders who threaten or actually sell bonds in protest of an issuing entity’s policies or financial situation, and in this case, it seems to be the US deficit.

They believe that the US government is supplying too much public debt, through the issuance of bonds, than investors are willingly able to absorb in an environment of elevated inflation and high interest rates. In protest, bond vigilantes dump bonds, which causes yields to rise. Bond vigilantes can also protest the actions of a central bank, like they did in the 1980s.

Those bond traders are seemingly up in arms over the government’s gaping budget deficit — something that occurs when the government’s spending outstrips revenues — which currently stands at roughly $67 billion so far for the current fiscal year.

For the full 2023 budget year, the Congressional Budget Office estimated that the deficit stood at a staggering $1.5 trillion.

The national debt and the deficit aren’t the same thing, but they go hand-in-hand. The debt includes both the government’s borrowing because of the deficit and the interest paid to investors who bought those securities.

“As the federal government experiences reoccurring deficits, which are common, the national debt grows,” according to the Treasury Department.

Treasury issues debt during periodic auctions to fund its spending.

They say that the government’s fiscal situation is unsustainable, given that the US debt-to-GDP ratio is near record levels and is only expected to increase.

In fact, Federal Reserve Chair Jerome Powell himself said Friday during a moderated discussion in Atlanta that previous Fed chairs have generally agreed that the federal budget “is on an unsustainable path.”

Before the Bell sat down with Joe Quinlan, head of CIO market strategy for Merrill and Bank of America Private Bank, on the perspective of bond vigilantes on the heels of a banner month for bonds in November.

(This interview has been lightly edited for length and clarity.)

Before the Bell: Why did bond vigilantes come back into the fray?

Joe Quinlan: When you have such a robust economy, it’s very unusual for bond traders to see the government run these huge budget deficits when you’re growing at the rate that we’ve been growing. Budget deficits are typically pandemic related or recession related, so that makes the credit market be on edge, and the deficit is larger because of less revenue, too. I can tell you from talking to clients, that’s top of mind. How do we manage the budget deficit? Does that require more tax? Can you inflate it away? Can you grow out of it? So that’s very top of mind amongst creditors. It’s not just the spending, it’s also the lack of revenue.

Why do those traders care so much about the deficit exactly?

There are a lot of moving parts and potential implications of the deficit. It could mean we go into fiscal consolidation after the first half of this decade, which is when government policy is focused on reducing the deficit. There’s a lot of interest on the deficit because of what it means for credit, for growth, for funding, who’s paying for what, and how do we lower it, so the interest from traders is really across the board. This is all important because of the structurally higher cost of capital, structurally higher defense spending, just given the world that we’re in, and interest payments have also structurally moved higher in terms of what we have to pay to service that debt. There are some cyclical and structural issues here at play.

Given the current fiscal situation and the fact that the bond market just enjoyed a remarkable month, what’s next for bonds?

Our interest rate team is looking at the 10-year (US Treasury) yield to be closer to 4% than 5% next year. You’d have to forecast a recession or deep downturn in the economy to get below 4% and stay there, like 3.5%, because you’d be looking at a much weaker economy, which we don’t see. That’s kind of where we’ve historically been in certain periods like the ’80s and ‘90s, but a lot of things still have to go right in that sense. It’s also important to remember that foreigners own 20% of US Treasuries, so we need that foreign participation. Fortunately, the US economy is the strongest in the world.

Investors have mostly concluded that the Federal Reserve is done hiking interest rates and are already looking toward rate cuts next year, possibly as early as in the first half of 2024.

Fed Chair Jerome Powell says: Not so fast.

“Having come so far so quickly, the [Fed] is moving forward carefully, as the risks of under- and over-tightening are becoming more balanced,” Powell said Friday in opening remarks before a moderated discussion at Spelman College in Atlanta.

“It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease,” he said.

Powell’s comments come less than two weeks ahead of the central bank’s upcoming policy meeting, on December 12-13. The Fed is widely expected to hold interest rates steady at a 22-year high for the third consecutive meeting.

While Powell and other officials say they’re not even thinking about cutting rates just yet, some investors expect cuts to begin around the middle of next year.

For a frozen US housing market struggling with dwindling sales and record low affordability, loosening monetary policy bodes well for lower mortgage rates.

The Fed does not directly set mortgage rates, but its actions influence them.

Mortgage rates track the yield on the 10-year US Treasury note, which moves in anticipation of monetary policy moves, what the Fed ends up doing and investors’ reactions. With Treasury yields sliding in recent weeks, so have mortgage rates, and rate cuts next year would help that along.

Still, Powell and other Fed officials could be keeping more hikes on the table in case inflation proves to be more stubborn than anticipated — but that possibility is not reflected in futures. It’s unclear how, or even if, the Fed will acknowledge an end to rate hikes in this cycle.