ANALYSIS — Long-term interest rates on government debt have spiked since the start of the new year, a phenomenon that usually occurs when investors expect robust economic growth, hotter inflation or both. And some market analysts say there’s room for rates to run higher — never a good sign for U.S. debt forecasts and the appetite of fiscal hawks for more deficit spending.
The benchmark 10-year U.S. Treasury yield, which influences lending rates throughout the economy, hit nearly 1.8 percent this week as Federal Reserve minutes showed central bankers might unwind their unprecedented monetary policy stimulus faster than expected, and Friday’s jobs report didn’t do anything to blunt those expectations. Yields haven’t been this high since January 2020 and are up from around 1.5 percent a week ago, an indicator that federal borrowing costs are on the rise.
Despite causing more than a half-million new cases daily and even closing down some schools again, the omicron COVID-19 variant is considered less severe than prior virus iterations, and market participants are looking beyond the recent wave to a continued economic revival. Recognizing that inflation is no longer “transitory,” the Fed is responding with actions to try to cool down the price rises that have hit consumers’ wallets over the past year.
While inflation is expected to subside somewhat from recent highs, investors’ forecast of the average consumer price index rise over the next five years is hovering around 2.8 percent — down from mid-November, though higher than before Christmas amid omicron fears. Inflation and higher interest rates usually go hand in hand as investors sell off fixed income holdings in search of greater returns; when bond prices drop, yields rise.
And there is another phenomenon at work: Jim Caron, chief fixed income strategist at Morgan Stanley, says investors are pricing in a huge run-up in Treasury debt supply over the coming year after it was temporarily depressed in part by massive Fed intervention. The Fed’s “quantitative easing” program, in which the central bank has been snapping up huge volumes of longer-term Treasury debt to inject money into the economy, which helps keep rates low and stimulate borrowing, is coming to an end.
The Fed is “tapering” its monthly bond purchases down from $80 billion a month through last November down to zero in March, when the first of multiple short-term interest rate increases is expected. And this week’s release of Fed minutes from its Dec. 14-15 meetings show there’s talk that the Fed around the same time may even start shrinking its hefty portfolio of Treasuries — now about $5.7 trillion worth — most of which is debt maturing in two or more years.
Using Goldman Sachs projections of Treasury debt issuance and backing out the Fed’s expected net purchases, Morgan Stanley’s Caron estimates the supply of longer-term Treasury debt available to global investors will be $1.55 trillion this year. That’s nearly $1 trillion in additional debt that investors other than the Fed would need to buy compared with last year, when the comparable supply was $582 billion. In other words, more than 2.5 times what the market needed to swallow last year.
With more supply on the market, investors are able to demand greater compensation in the form of fatter yields, pushing rates higher. The market’s appetite will be tested next week when Treasury auctions off 3-year, 10-year and 30-year debt totaling $110 billion. December consumer price index data is also set for release on Jan. 12, after registering a hefty 6.8 percent year-over-year rise in November.
Holding the keys
Independent forecasters like the Congressional Budget Office, which is getting set to issue its updated debt projections, will be watching the path of interest rates and inflation closely.
Someone else who will be watching is Sen. Joe Manchin III, D-W.Va., who holds the keys to President Joe Biden’s roughly $2 trillion package of clean energy incentives and safety net program spending in his hands. And Manchin already put the entire plan on ice last month when 10-year Treasurys were still trading south of 1.5 percent.
One of Manchin's fears is that the budget bill, dubbed “Build Back Better” by its supporters, will fuel inflation since it would spend money upfront while spreading its “pay-fors” out over a decade. Furthermore, he’s afraid lawmakers will simply come back and extend expiring programs, adding trillions of dollars more to the debt.
But it is worth noting that over the summer when party leaders were trying to rally Manchin around their fiscal 2022 budget resolution — which was needed to unlock the reconciliation process for a filibuster-proof bill — one of his conditions was that the Fed end its quantitative easing program.
“I am deeply concerned that the continuing stimulus put forth by the Fed, and proposal for additional fiscal stimulus, will lead to our economy overheating and to unavoidable inflation taxes that hard working Americans cannot afford,” Manchin wrote in an Aug. 5 letter to Fed Chairman Jerome Powell.
With the Fed winding down its unconventional monetary policy on a faster timetable than anyone thought, Manchin is seemingly getting his wish. Now it’s up to Biden and Democratic leaders to work with Manchin on a fiscal package that meets his demands, or risk seeing several signature campaign promises go up in flames ahead of crucial midterm elections.
Peter Cohn is CQ Roll Call’s fiscal policy editor.