The Seminal Question Today

What is the seminal question for investors? Over the past 200 years, it has always come back to the government bond markets.  If investors lose confidence in a currency or a government’s fiscal policy and impose too high a refinancing cost, it either has to come to heel or take more dramatic action such as help from the IMF or some form of default.

Bond-markets vs politicians

That is why Bill Clinton’s adviser, James Carville, famously said he’d like to be reincarnated as the bond market, because he could intimidate everybody.  It’s also why, when I started my career as a blue-button on the London stockmarket floor, the bond desk was far more important than equities.

Responsible governments have tended to use long-term bond markets to finance their debt, because it reduces the risk of having to refinance frequently.  For example, the U.K.’s average debt maturity is over 13 years is one of the longest, and compares with just under 6 years in the U.S.  The risk of more frequent refinancing is that investors have more regular chances to send an unwelcome signal to the government.

Long-term bond yields are also considered as the best proxy for a risk-free rate in financial academia and market practice.  Credit spreads and other risk premia are calculated off them as are valuations of future income streams such as annuities.  So how governments respond to pressure from bond markets really matters to all investors.  

One response is to give in.  On Black Wednesday in 1992, the U.K. government left the ERM (Exchange Rate Mechanism, the precursor to the Euro) because speculators, most famously George Soros, sold sterling and U.K. assets.  Bond yields and especially interest rates went to levels which everyone knew could not be sustained.

Governments can of course choose to pay the higher price of refinancing and carry on spending.  However, ignoring market pressures has never historically worked for long.  It will inevitably lead to either inflation or some form of default, as many countries have found out.  But perhaps the most common response is to take the markets on, using the weapons at a government’s disposal.  At its bluntest, this will take the form of some default i.e. reneging on the terms originally offered.  For example, over time the interest rate on the U.K.’s consolidated bonds, (dating back to 1751), was reduced from 3.5% to 2.5%.

In the modern world, it is usually done a little more delicately.  The Bank of Japan succeeded in keeping the 10-year bond yield close to 0.0% between 2016 and early 2024.  Yes, I know that seems like the last century, but it wasn’t.  Markets put a lot of pressure on them, but the authorities succeeded by dint of buying up 100%, and in some cases even more, of the bonds they issued.  It was not default, but it did succeed in distorting bond yields at the 10-year tenor from where the market would naturally have landed.  However, ultimately they had to yield to market forces.

U.S. finances are at a tipping point

Today, the U.S. federal finances are at a tipping point. The clearest evidence is the higher price bond markets are demanding to purchase 10-year and 30-year bonds at auctions.  Their concerns centre on the inexorable rise in U.S. debt, now at US$40 trillion, or over 120% of GDP.  The primary deficit is around 6% of GDP, the bulk of which (4.2%) is debt service.  That doesn’t even include the approximately 20 to 25% of financing which is done through Treasury bills of less than 2 years duration issued at a discount.  Because they don’t pay a coupon, they don’t appear in the cost of debt service data.

The level of debt is not far out of line with several other western countries (France and the U.K., for example), but the trajectory is far worse.  The primary deficit is set to rise further, with the wars the U.S. is directly or indirectly involved in costing about 1% of GDP per year.  The average cost of all U.S. debt is guaranteed to rise from 2025’s 3.4% (up from 2.1% in 2021).  On the other side there is no sign of any appetite to raise domestic taxes, and tariffs are not bringing in the anticipated sums.

The authorities are taking the bond markets on.  The average debt maturity is being held at historic levels as the Treasury buys back long-dated bonds and The Federal Reserve has recently financed increasingly through short-dated notes.  Because the yield curve is sloping upwards, this reduces the cost of funding and also improves the optics.  But it is now distorting the whole yield curve from the short end to the long end.  Warsh may say he wants to see genuine ‘unintermediated’ market signals, but this isn’t them.

Who will win?

The seminal question today is who is going to win this struggle?  Will the Fed and the Treasury (because they are working together) be able to do what the BoJ did and browbeat the markets?  Or will the bond-markets be able to intimidate them as they have in the past?  A lot rests on this.

The day that investors refuse to buy U.S. government issued securities, whether short term or long term, is the day that this might change.  Is it imminent?  The short answer is no, despite the ominous signs from recent auctions.  Will it happen one day?  I think it is odds on.

Investors are conditioned, and in some cases pressurised, to hold U.S. Treasuries.  As the bedrock of almost all academic finance, their status is almost like gold’s was, in the days when all currency was backed by either gold or silver.  That is why even China has a significant holding.   

As the world’s core ‘risk-free’ asset, it would take a major shock for investors to change their behaviour.  But there has to be a pressure release valve somewhere, and the prime candidate is the U.S. dollar.  I doubt there would be another Black Wednesday, because the U.S. has too much firepower, but persistent dollar  weakness would act as a constraint.  

The future course of inflation is another potential catalyst for a show-down.  It is not so much today’s rate, which is higher but not much so than its rivals, as the prospect of inflation in the future, i.e., the direction of travel towards the magic money-tree.  The U.S. government will have every incentive to inflate its debt pile away, and without a Volcker at the Federal Reserve to restore faith, investors might take fright.

Are we already off to the magic money-tree?

I will also ask a second question: in the event that bond-markets or some other actor is able to stop the U.S. government in its tracks, is it already too late?  In 1979 Volcker succeeded in squashing inflation by raising interest rates to an eventual 20%, but in today’s political climate that looks completely unfeasible.  No U.S. administration, let alone the current one, will be willing to precipitate the kind of recession that engendered.

My best guess when peering into the future, is that there will be a level of fudging for some time, with the aim of keeping interest rates and bond yields at around current levels and the economy growing.  As this becomes gradually more apparent, the consequences are likely to be a higher and more persistent level of inflation and a weaker dollar.  The pressures on U.S. Treasury yields will continue to grow, and one day they will explode.  But that day is still looking some time away.