Huge US government borrowing adds to bond market pain

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A step-up in borrowing by the US government has deepened a decline in bond markets that has sent yields to their highest point since 2007, analysts and investors say.

Much of the recent bond rout reflects a shift in expectations about the future path of interest rates and economic expansion. Friday’s data showing strong US jobs growth heaped further pressure on bond prices, as it added to the anxiety that interest rates will need to stick at high levels to defeat inflation.

But investors and analysts say a recent deluge of new debt hitting the market has also pushed yields higher, particularly on longer-dated bonds that have been hit hardest. Demand from big Treasury buyers such as foreign investors, foreign central banks and US banks has meanwhile remained stagnant.

Changes in the supply of Treasuries have not historically been major drivers of bonds. Yields sank to historic lows despite vast fiscal spending programmes in the coronavirus pandemic, for instance. However, the current surge is happening as the biggest buyer of Treasury bonds — the US Federal Reserve — continues to step back from the market.

“We’ve seen this extraordinary level of issuance and little sign that there will be any fiscal reining in as we look ahead,” said Andrew McCaffery, chief investment officer at Fidelity International. “The markets have been saying that the US cost for borrowing needs to be higher.”

To bridge widening budget deficits and make up for lower tax revenue, the US government has ramped up its borrowing this year, with about $1tn of bonds expected to be issued in the three months to October. Trade body Sifma notes that net issuance has so far this year hit $1.8tn, which is already the second-highest tally on record behind the early stages of the pandemic in 2020, when the Fed hoovered up lots of the extra bonds under its asset purchase programme. 

Issuance is expected to continue to rise. Torsten Slok, chief economist at Apollo Global Management, says he expects Treasury auction sizes to increase on average by 23 per cent in 2024.

The scale of borrowing has not come as a surprise to bond investors; the Treasury department released its latest plans in August. But analysts say the market has only gradually adjusted to the relentless issuance.

“The market knows and understands what the supply numbers look like from the Treasury,” said Meghan Swiber, a US rates strategist at Bank of America. “We have a good sense of what those deficits will be. But the actual flow impact of that supply did not hit us immediately. And a lot of the impact is still ahead of us.”

The supply of Treasuries had already increased sharply since the global financial crisis, as the US boosted issuance to pay for then-president Trump’s tax cuts, and following that during the pandemic. The Treasury market is roughly $25tn in size today, five times what it was at the beginning of 2008. But now, sharply higher borrowing costs will also add to the government’s expenses.

In the face of the increase in supply, foreign investors and foreign central banks — a cornerstone of demand in the Treasury market — have kept their purchases relatively steady over the past year, according to Exante Data.

Demand from Japan and China, the biggest foreign holders of Treasuries, has been relatively stable this calendar year, although it has dropped as a percentage of the total Treasury market, according to Brad Setser, a senior fellow at the Council on Foreign Relations.

The same trend is true for US banks, historically among the biggest buyers of Treasury bonds. Banks’ holdings of Treasuries and agency mortgage-backed securities dipped to around $4tn in late September from an all-time high of $4.7tn in February 2022, according to data from the Fed. Less demand from banks is mostly attributable to changes in regulation after the global financial crisis that made it more expensive for banks to hold bonds. More recently, banks have also shied away from the market after losses on debt holdings contributed to the demise of Silicon Valley Bank in March.

“More than anything, banks have not been coming to the scene to buy these Treasuries,” said Fahd Malik, a fixed income portfolio manager at AllianceBernstein. “There’s no marginal buyer, so that increases these moves. This economic data shouldn’t be moving the market as much as it has been.” 

Analysts said fiscal concerns have also helped to push up borrowing costs in parts of Europe. The UK was given a warning shot last year when former chancellor Kwasi Kwarteng announced a £45bn package of unfunded tax cuts, sparking turmoil in the bond market and leading to intervention by the Bank of England. 

More recently, Italian yields climbed last month after Rome raised its budget deficit target for this year and next. Ten-year borrowing costs touched 5 per cent this week for the first time since 2013, before pulling back to 4.9 per cent. 

“Where Italy’s trading, we are easily at levels where you would question if its debt is sustainable,” said Tomasz Wieladek, chief European economist at T Rowe Price.