Earlier this month, rising interest rates triggered an explosion of volatility, resulting in the Dow Jones Industrial Average’s largest single-day points drop ever. And while stocks have since rebounded on a classic buy-the-dip dynamic, yields continue to grind higher.
The 10-year Treasury yield is flirting with the 3% threshold. The two-year yield is approaching 2.3%, rising above the pre-selloff high to hit levels not seen since September 2008 and up from a low of 0.56% set in the summer of 2016.
Some of this stems from expectations for higher inflation and faster economic growth. Some is a realization that the pace of the Federal Reserve’s rate-hike campaign could quicken, a notion reinforced by the release of the latest Fed meeting minutes, where most policymakers saw stronger growth lifting the likelihood of further rate hikes.
And now, a growing appreciation on Wall Street for the US Treasury’s worsening fiscal stance—something that sets the stage for more market fireworks in the weeks and months to come.
For private market participants, there is no shelter to be had. Higher borrowing costs will cause many of the favorable dynamics enjoyed in recent years to reverse. Everything from a “reach for yield” clamoring resulting in an overplus of dry powder to expensive deal terms being compensated for by a lowered cost of capital. So, take heed.
Why? It’s simple supply and demand. The supply of Treasury bonds is set to soar, with the recently passed federal budget deal expanding federal spending as the deficit overall nears 5% of GDP in size.
The result, according to the Committee for a Responsible Federal Budget, is that the annual deficit will push past the $1 trillion threshold in 2019 and increase the national debt to 105% of GDP by 2027.
At the same time, the demand for these Treasury bonds is diminishing as the Fed not only raises interest rates—by selling Treasury bonds in exchange for cash, reducing the money supply—but quickens the pace of its “quantitative tightening,” the process by which years of bond-buying stimulus is being reversed. At the end of January, the Fed’s balance sheet fell to levels not seen since September 2014, before rebounding slightly.
Currently, the Fed reinvests the payments it receives on its holdings of government bonds and mortgage-backed securities. This increases the demand for long-term bonds.
But beginning last October, the Fed only reinvests proceeds that exceed a steadily increasing cap. Initially set at $6 billion per month for Treasuries and $4 billion for mortgages, they will be lifted in three-month intervals until they peak at $30 billion for Treasuries and $20 billion for mortgages in about a year’s time.
Increased supply and lowered demand? That’s a recipe for lower bond prices. And thus, much higher interest rates.
As I discussed in a previous post, merely a 1% rise in rates could result in a $1.2 trillion loss to the bond market, according to estimates by the US Treasury—with the total climbing when one accounts for various derivatives, mortgages and other assets tied to rate dynamics.
Moreover, Goldman Sachs economists led by Jan Hatzius pointed out in a recent note to clients that the situation risks becoming self-reinforcing: Higher deficits and higher interest rates will push up the Treasury’s interest expense, further increasing the need to raise the national debt and resulting in even higher interest payments as a percentage of GDP.
This dynamic, in their words, “raises eventual sustainability questions if left unchecked.”
For private markets, the first evidence of trouble will likely be felt in the high-yield and leveraged loan markets. Yields should rise. Not only in sympathy with Treasuries but will also get a boost from a likely widening of credit spreads from near historic lows as investors are forced to discount increased default risks.
Related read: A look at KKR’s recession warning
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