Why America borrows like it's in a crisis

The United States ended fiscal year 2024 with a budget deficit of $1.83 trillion, or 6.4 per cent of GDP, at a time of peacetime full employment. Borrowing on that scale used to be kept for wars and deep balance-sheet recessions. Running an emergency-sized deficit during an expansion is a procyclical gamble with no modern precedent, and it is bending the whole yield curve out of shape.

How the gap opened

The deficit did not appear by accident. The 2017 tax cuts lowered revenue without the growth dividend their backers promised, and the pandemic packages of 2020 and 2021 left spending on a permanently higher base. Social Security and Medicare costs are rising as the baby-boom generation retires, and neither party has proposed serious changes to either programme. The one bipartisan fiscal agreement of recent years, the 2023 deal that suspended the debt ceiling, trimmed discretionary spending at the margins and left the structural gap untouched.

Too many bonds to sell

The sums facing the Treasury Borrowing Advisory Committee are now mechanical. Selling nearly two trillion dollars of net new debt while the Federal Reserve runs down its balance sheet means auctions big enough to stretch the primary dealers. Net interest costs now exceed the defence budget. The debt has begun to feed itself, with the Treasury borrowing to pay interest on what it has already borrowed.

The mechanism is simple enough. Much of the debt issued when rates were near zero is now maturing and being rolled over at yields of four per cent or more, so the interest bill rises even if the deficit stops growing. The Treasury has leaned on short-dated bills to avoid flooding the market with longer bonds, but that only shortens the average maturity of the debt and makes the interest bill more sensitive to the Fed’s policy rate. Every auction also has to clear against a Fed that is no longer a buyer, since quantitative tightening lets its holdings run off rather than reinvesting them.

The buyer base has changed in ways that matter for price. Japan remains the largest foreign holder of Treasuries, but China has let its holdings shrink for years, and the reserve managers who once bought regardless of yield have been replaced at the margin by pension funds, insurers, hedge funds and households who buy only when the price is right. Hedge funds have become large buyers through basis trades, in which they hold cash bonds against short futures positions financed in the repo market. That trade adds demand in calm conditions but can reverse abruptly when funding markets tighten, as it did in March 2020.

Investors want paying

Congress has no plan to close the gap, so bond markets have to charge a rising premium for fiscal risk. Foreign central banks no longer soak up Treasuries as they once did, which leaves price-sensitive domestic fund managers to clear the auctions of middle maturities. The evidence is in the curve. The Fed has cut its policy rate by a full percentage point since September, yet ten-year yields have gone up rather than down, and estimates of the term premium have turned positive again after years below zero.

Lessons from London and the 1960s

The closest warning comes from Britain. In September 2022 an unfunded tax-cutting budget sent gilt yields soaring so fast that the Bank of England had to intervene and the prime minister was gone within weeks. America’s reserve-currency status protects it from anything so abrupt, but not from the slower version. The better domestic parallel is the late 1960s, when Washington paid for the Vietnam war and the Great Society at the same time as the economy ran hot, and the bill arrived as the inflation of the following decade. Rating agencies have already registered the drift: Fitch cut America’s credit rating in August 2023 and Moody’s moved its outlook to negative a few months later.

Who pays the premium

Higher long yields fall hardest on borrowers who price off the ten-year note. Mortgage rates have stayed high even as the Fed has cut, which keeps the housing market frozen, and companies that need to refinance debt taken on cheaply in 2020 and 2021 will face noticeably higher coupons. Savers with cash and short-dated bonds do well for now, and the dollar tends to benefit from higher American yields. The losers abroad are emerging-market borrowers whose own rates are set, in effect, by the Treasury market.

The case against alarm

The optimists have a point. The dollar remains the world’s reserve currency, American growth has outrun that of every other large rich economy, and demand at Treasury auctions has so far held up without a failed sale. Nominal GDP growth has also flattered the debt ratio. But those comforts rest on growth staying strong and inflation staying tame at the same time, and the deficit leaves no margin if either slips. A shock that pushes the deficit higher from an already high starting point would test investors’ patience far more than the present gap has.

What will move the curve

The first test is close. The debt ceiling returned on January 2nd, and the Treasury has warned that it will need extraordinary accounting measures within weeks to keep paying its bills. The individual tax cuts from 2017 expire at the end of 2025, and the incoming Republican majority wants to extend them, which on its own would widen the deficit further. Washington has spent its fiscal room during a boom and will have none left when the next recession comes. Long yields will probably keep rising faster than short ones until Congress shows it can cut the deficit, and a tax bill that extends the cuts without offsets would push ten-year yields higher this year.