Over the past few weeks, a troubling trend emerged in the market for U.S. debt. That trend has taken a break: the past week was quiet with, for the most part, stable interest rates in the open, so-called secondary market for Treasury securities (the market where the public can invest).
It was also a stable week at the auctions for Treasury securities, with two exceptions:
- The 3-year Treasury note paid 4.21% at the auction on March 11th, up from 4.07% two months earlier;
- The 10-year note paid 4.1% at the March 12th auction; on January 10th it paid 3.96%.
In the midst of market stability, it is interesting that the only visible trend is one with upward interest rates, and that this trend is found among the type of securities—notes—that mature in more than one year. This shows that, despite the calm surface of the debt market, investors are still pessimistic in their long-term outlook.
Although it is always nice when there is calm and stability in the markets for sovereign debt, it would be a mistake to misinterpret the past week’s trendless U.S. market as a sign that all is well. Longer trends often take a break when investors consolidate their portfolios and evaluate recent market gains (and losses), but this also happens when there is big news coming.
In the case of the U.S. economy, the calm before the storm is the anticipation of the March 19th meeting of the Federal Reserve’s Open Market Committee, FOMC. At this meeting, the FOMC will reveal just how conservatively the Federal Reserve will move forward with cutting its policy-setting federal funds rate.
Around New Year, the general sentiment among analysts and commentators was that the Fed would begin cutting its funds rate at its meeting in March. I shared that view, but I cautioned it with the economist’s classic escape clause: ‘ceteris paribus’ or ‘all other things equal’. I have repeatedly pointed out that just a few adverse numbers will motivate the FOMC to postpone its rate cuts.
I have even cautioned that there is a possible but improbable scenario where the Fed could shift to raising its funds rate. That scenario remains remote, but its probability will rise quickly if the market gets back to its recent trend of weakening investor confidence. As Michelle Bowman, a member of the Board of Governors of the Fed, explained on March 7th, the debt is the key variable behind the Fed’s policy decisions.
Bowman describes the U.S. economy as strong and stable; there are no macroeconomic reasons to cut the federal funds rate. Likewise, inflation data contain no reason for rate cuts. In other words, with inflation slowly in decline and the macroeconomic situation being as good as it is, the Fed is just as happy keeping the federal funds rate at its current level—for now.
This is the story that most analysts have noticed. But what is being overlooked is a point that Federal Reserve Governor Bowman presented, but cleverly buried in her speech; in the transcript, it shows up in a thick paragraph halfway to the end of Bowman’s speech.
Let us listen to how she revealed it:
At its current setting, our monetary policy stance is restrictive and appears to be appropriately calibrated to reduce inflationary pressures.
This sentence is simply a summary of what Bowman says earlier in the speech, namely that the macroeconomic situation in the U.S. economy gives the Fed no reason to move the funds rate either way.
As I’ve noted recently, my baseline outlook continues to be that inflation will decline further with the policy rate held steady, but I still see a number of upside inflation risks that affect my outlook.
Here is where it gets interesting. The mention of “upside inflation risks” is not unique to Bowman, but rather a Fed talking point that has emerged recently. However, there are no apparent macroeconomic reasons why inflation should rebound upward, which Bowman acknowledges.
For the sake of formality, she mentions “geopolitical developments, including the risk of spillovers from geopolitical conflicts” as well as “supply chains” as potential causes of inflation. However, the always present “geopolitical” threat of inflation has been incorporated in monetary policy analysis since at least the oil crisis of 1973.
The reference to supply chains has never been a concern before, and it should not be a concern going forward either. To the extent there were genuine supply-chain problems during the 2020 pandemic, they are far behind us by now.
No, the “upside inflation risks” emanate from somewhere else. Back to Bowman:
There is also the risk that a loosening in financial conditions and additional fiscal stimulus could add momentum to demand, stalling any further progress or even causing inflation to reaccelerate.
This point, buried between the aforementioned references to geopolitics and supply chains on the one hand, and a general labor-market reference on the other, is the real worry here. Congress continues, day after day, week after week, months on end, to borrow money at a glaringly unsustainable pace. The total debt of the federal government is now close to $34.5 trillion, with a projected budget deficit in excess of $ trillion for the 2024 fiscal year.
So far this fiscal year, Congress has borrowed $8.9 billion every single workday.
The average interest rate on the current debt is 3.13%. As I like to remind people who think that this is not much to worry about: a year and a half ago, at the start of the 2023 fiscal year, that same rate was 1.87%. This trend of a slowly but steadily rising interest rate cost shows no signs of abating; as of March 12th, the annualized interest on the U.S. government’s debt was $1,075 billion.
A year and a half ago, the annualized interest cost was $579 billion. This means an 86% increase in a year and a half.
Where will it be a year and a half from now?
There is a higher than even chance that this question will be answered well before then, by investors in the debt market who lose so much faith in U.S. debt that they sell massive amounts—and in the bargain cause a sharp rise in interest rates. In response, Congress will be forced to take drastic, immediate action to rein in its deficit.
Another term for this scenario is ‘debt crisis’. It is this prospect that really motivates the Federal Reserve’s reluctance to adjust interest rates downward, if ever so slightly.
