Markets brief: Why the budget deficit suddenly matters
A jump in Treasury debt issuance is playing a role in the rise in bond yields.
The U.S. federal budget deficit isn’t new, but the level of attention it’s getting in the bond market these days is. And it’s playing a role in the big jump in bond yields.
For the most part, bond market participants say the rise in long-term yields seen since the beginning of August has come in response to the strength of the U.S. economy, as well as signals from the Federal Reserve that it envisions keeping interest rates “higher for longer.”
However, a recent, largely unforeseen, rapid expansion of the budget deficit is also at play, according to observers. That’s because a wider-than-expected deficit is leading the U.S. Treasury to sell more longer-term bonds than traders had been anticipating just a few months ago.
That is in turn leading to a classic supply-and-demand dynamic in the bond market. At a time when demand for long-term bonds is already weak thanks to the economy and Fed policy, extra supply leads to prices falling further than they otherwise might.
Just this past Thursday, for example, a U.S. Treasury auction of $20 billion in 30-year bonds saw weaker-than-expected demand. That sent bond prices into a renewed downturn, resulting in higher yields. Stock prices then took a hit on that rise.
The yield on the U.S. Treasury 10-year note finished Friday at 4.63%, down from a 16-year high of 4.81% on Oct. 3 but up substantially from 3.97% on July 31.
Lindsay Rosner, managing director of fixed income and liquidity solutions at Goldman Sachs Asset Management, says “That’s why the conversation has gotten louder” around the deficit.
The ripples from the federal deficit come as the bond market is undergoing what many investors call a secular change from the landscape seen for the past 15 years. For much of the time since the 2008 financial crisis, the Fed has kept interest rates artificially low to help stimulate the economy. Inflation was also at historically low levels through much of the past 15 years.
Now, in the wake of inflation hitting a four-decade high, interest rates are at their highest levels since 2007.
It’s not just that the economic backdrop has shifted; the fiscal picture has also changed dramatically.
Ballooning US deficit
Federal budget deficits have been the norm since 2001, when the U.S. government last recorded a surplus, meaning it took in more money than it spent. (In fact, since 1930, the United States has run a deficit in all but nine years.)
But this past year has seen the deficit (and forecasts for future deficits) grow unexpectedly large. This all is playing out through the inner workings of the government bond market, where Wall Street firms designated as “primary dealers” work in close consultation with the Treasury (and the Fed) in bidding for government bonds at auctions.
As part of the process, primary dealers provide estimates of the deficit to the Treasury. A year ago, the median estimate of the federal budget deficit was $1.02 trillion in 2023 and $1.275 trillion in 2025. It’s now projected by the Congressional Budget Office to be $1.4 trillion this year, $1.75 trillion in 2025, and nearly $2 trillion in 2028.
That much-wider deficit “was a big surprise” according to Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets, and that’s put the topic “on the front burner.”
A recent episode of Investing Compass covered the debt time bomb.
Why is the deficit growing?
Gwinn points to several factors that caught most forecasters off-guard—both on Wall Street and in the government. One was the extent of interest rate increases and their knock-on effects on U.S. government debt. Another was the impact of government spending, stemming from the big rise in cost-of-living adjustments on programs such as Social Security. A third issue was weaker-than-expected tax collections in 2022, which in part related to a big drop in capital gains taxes amid the bear market for stocks.
Rosner says it’s not just the current trajectory of the deficit that has investors wary of paying up for longer-term bonds. There’s also the fiscal outlook. For any bond buyer, “Part of the calculation is: Who are you actually lending to?” she says. “When you lend money to any company, or in this case the government, you want to figure out: What does their fiscal house look like? What is their balance sheet?”
Rosner continues: “When you think about the fiscal situation, you want to think about: Is there a world in which there can be an improvement, like fiscal restraint? What is the appetite for tackling the fiscal spend, and a fiscal spend that continues to balloon?” That question is especially complicated around an election year, she notes.
Bigger treasury auctions
The wider deficit is translating into bigger Treasury auctions than markets expected. On July 31, for example, the Treasury announced it needed to borrow more than $1 trillion in the third quarter—$274 billion more than it estimated in May.
Not only does the government need to raise more money, but the Treasury is also shifting the kinds of debt it has been selling. Gwinn notes that until recent months, the Treasury had been handling its greater borrowing needs through the sale of bills. However, it’s now shifted those stepped-up debt sales to Treasury notes. “We’re moving into unforeseen places” in terms of the amounts of longer-term debt, he explains.
Along with the Fed’s higher-for-longer message, this supply pressure has contributed to the unusual trend in one of the bond market’s most widely-watched measures: the shape of the yield curve. The yield curve is essentially a visual depiction of yields along the spectrum of maturities. Most of the time, yields on longer maturities are higher than those on shorter-dated debt, which reflects the risks of holding bonds for longer periods.
However, at certain times, like now, the shape of the yield curve can flip, with short-term yields rising above long-term yields. That’s known as an inverted yield curve, and it’s often seen as a harbinger of a recession.
As the Fed aggressively raised short-term rates, the yield curve inversion got to its most extreme levels since the early 1980s. This July, the yield on the 2-year note stood more than 1 percentage point above the 10-year’s. However, with the jump in long-term yields since the beginning of August, that gap has rapidly narrowed to roughly 0.36 percentage points.
At Fidelity Investments, fixed-income portfolio managers Jeff Moore and Michael Plage point to how concerns about deficits affect the yield curve. “Questions will inevitably include if and how they will be reduced and be financed. In our view, continued very large fiscal deficits could fuel some uncertainty and lead to even more yield curve steepening,” they say.
