Inflation and deficits don't dim the appeal of US bonds

New York

MARKETS have been in upheaval. The Federal Reserve is taking steps to cool off the economy as questions loom about the course of the recovery. And headlines are proclaiming that government bond yields are near two-year highs.

But the striking thing about bonds isn't that yields - which influence interest rates throughout the economy - have risen. It's that they remain so low.

In the past year, with consumer prices rising at a pace unseen since the early 1980s, a conventional presumption was that the demand for bonds would slump unless their yields were high enough to substantially offset inflation's bite on investors' portfolios.

Bond purchases remained near record levels anyway, which pushed yields lower. The yield on the 10-year Treasury note - the key security in the US$22 trillion market for US government bonds - is about 1.8 per cent. That's roughly where it was on the eve of the pandemic, or when Donald Trump was elected president, or even a decade ago, when inflation was running at a mere 1.7 per cent annual rate - compared with the 7 per cent year-over-year increase in the consumer price index recorded in December.

If you had run that data past market experts in the spring, "I think you would have been hard-pressed to find anybody on the Street who'd believe you," said Scott Pavlak, a fixed-income portfolio manager at MetLife Investment Management.

Because the 10-year Treasury yield is a benchmark for many other interest rates, the rates on mortgages and corporate debt have been near historical lows as well. And despite a binge of deficit spending by the US government - which standard theories say should make a nation's borrowing more expensive - continuing demand for government debt securities has meant that investors are, in inflation-adjusted terms, paying to hold Treasury bonds rather than getting a positive return.

The major reasons for this odd phenomenon include long-term expectations about inflation, a large (and unequally distributed) surge in wealth worldwide and the growing ranks of retiring baby boomers who want to protect their nest eggs against the volatility of stocks.

Potentially huge consequences

And that has potentially huge consequences for public finances.

"If governments ever wanted to engage in an aggressive programme of spending, now is the time," said Padhraic Garvey, a head of research at ING, a global bank. "This is a perfect time to issue bonds as long as possible and proceed with long-term investment plans - and as long as the rate of return on those plans is in excess of the funding costs, they pay for themselves."

Because the government debt issued by the United States is valued, with few exceptions, as the safest financial asset in the global market - and because this debt is used as the collateral for trillions of dollars of systemically important transactions - the monthly and weekly fluctuations of key US Treasuries, like the 10-year note, are watched closely.

There are rancorous debates about the added role that the emergency bond-buying programme conducted by the Fed since March 2020 - which included hundreds of billions of dollars in US debt securities - has played in keeping rates down.

Some of the central bank's critics concede that the Fed's aggressive measures (which officials are dialling back) may have proved necessary at the start of the pandemic to stabilise markets. But they insist its programme, another form of economic stimulus, continued far too long, egging on inflation by increasing demand and keeping rates low - an equation that hurt savers who could benefit from higher returns to hedge against the price increases.

Still, most mainstream analysts also tend to identify a broader gumbo of coalescing factors beyond monetary policy.

Several major market participants attribute these stubbornly low yields despite a high-growth, high-inflation economy to a widening sense among investors that a time of slower growth and milder price increases may eventually reassert itself.

Post-pandemic world

"While inflation has surged, they do not expect it to be persistent," said Brett Ryan, senior US economist at Deutsche Bank. "In other words, over the long run, the post-pandemic world is likely to look very similar to the pre-pandemic state of the economy."

Long-run inflation expectations are still relatively anchored at an annual rate of about 2.4 per cent over the next 10 years.

This indicates that markets think the Fed will prevent inflation from spiralling upwards, despite the huge increase in debt and the supply of US dollars.One potent element driving down rates is that from 2000 to 2020 - a stretch that included a burst dot-com bubble, a breakdown of the world's banking system and a pandemic that upended business activity - global wealth in terms of net worth more than tripled to US$510 trillion. The resulting savings glut has deeply affected the market, particularly for government bonds.

The vast majority of wealth has accumulated to borderless corporations and a multinational elite desperate to park that capital somewhere that is safe and allows its money to earn some level of interest, rather than lose value even more quickly as cash. They view lending the money to a national government in its own currency as a prudent investment because, at worst, the debt can be repaid by creating more of that currency.

The downside for these investors is that only so many stable, powerful countries have this privilege: This mix of exorbitant levels of wealth and a scarcity of safe havens for it has whetted, at least for now, a deepening appetite for reliable government debt securities - especially US Treasuries.

"To have truly risk-free returns and storage of your dollars, where else are you going to put them?" asked Daniel Alpert, a managing partner of investment bank Westwood Capital.

The US Treasury market has grown to roughly US$23 trillion, from US$3 trillion two decades ago - directly in step with the national debt, which has grown to over 120 per cent of gross domestic product, from 55 per cent.

But borrowing costs for the US government have trended lower, not higher. Congress issued roughly US$5 trillion in Treasury debt securities to finance pandemic fiscal relief, "and we had, effectively, zero cost of capital for most of it", said Yesha Yadav, a law professor at Vanderbilt University whose scholarship covers the Treasury market's structure and regulations.

The cost of the interest payments that the US government owes on its debt peaked in 1991 at 3.2 per cent of gross domestic product, when the national debt was only 44 per cent of GDP. By that measure, interest costs now are about half what they were back then.

"If the world's demand to hold Treasury securities is strong enough, then running budget deficits can be sustainable," said David Beckworth, a former international economist at the Treasury who is now a senior research fellow at George Mason University's Mercatus Center, a libertarian-oriented think tank.

Nation's debt burden

The real cost of servicing the debt "has been very low," said Jared Bernstein, a leading economic adviser to President Joe Biden. Treasury Secretary Janet Yellen has made similar assertions about the nation's debt burden in recent months. And this "real cost" framing was used as a rhetorical salve of sorts when Democrats, joined by 19 Republicans, enacted a US$1 trillion infrastructure bill that is expected to increase deficits by more than US$250 billion.

Bernstein stipulated that while debt financing has its place, the White House also believes it has firm limits within its agenda. "The outcome of all this is going to be some mix of progressively raised revenues and investments in essential public goods with a high return financed by some borrowing." NYTIMES