You are going to see a crack in the bond market. – Jaime Dimon
When Jaime Dimon, JPMorgan Chase CEO, spoke at the Reagan National Economic Forum last week, he warned of a coming crisis in the bond market due to the growing US national debt. He said, “I don’t know if it’s going to be a crisis in six months or six years, and I’m hoping that we change both the trajectory of the debt and the ability of market makers to make markets.” This analysis aims to look at how close the bond market might be to his predicted crisis.
US Treasury Yields
Notably, 10-year US Treasury yields reached their nadir when the betting odds of a recession were at their highest. As one should expect, yields have risen as the odds of a recession have declined. Directionally, the move in yields makes complete sense, though one can argue that yields have increased more than is warranted. It seems clear that at least the 10-year US Treasury yield isn’t acting in an extreme fashion.
Fiscal Policy
Without exception, the fiscal position of large countries, including the United States, as measured by government debt relative to GDP, deteriorated due to the impact of spending during the pandemic. Most countries had already been increasing their debt relative to economic activity, but the pandemic accelerated this trend.
According to Strategas, once US debt servicing costs, as a percentage of tax revenues, rise above 14%, there tends to be some fiscal strain and fiscal austerity results. The US passed that interest cost level in July 2023 and is now at around 18%. The debate about the US tax bill in the Senate will be interesting to watch as it might reflect some of these concerns.
There is no magic level of debt-to-GDP that signals disaster since countries with a more resilient economy can service more debt. Generally, the deterioration in government fiscal health is a global issue. In addition, with yields rising following the pandemic, other countries also face the higher interest costs previously discussed for the US.
Global Yields
Are global yields reflecting growing concerns about government fiscal health? Despite the talk about rising bond yields in the US, the 2- and 10-year Treasury yields have declined year-to-date. One area where a consistent theme of higher interest rates is evident is in the long-term maturities. Japan is particularly notable given the combination of a massive debt load and a 30-year bond yield that has risen the most year-to-date.
Term Premium
The term premium refers to the additional yield demanded by investors for holding longer-term bonds. This premium can include compensation for interest rate risk, inflation uncertainty, credit risk, and other factors. However, at times, the 30-year Treasury yield has been below the 2-year yield. Generally, when this happens, investors seek interest rate risk because they expect short-term interest rates to decline.
The simplest definition of the term premium is to subtract the yield on the shorter-term bond from the yield on the longer-maturity bond. In this case, the 30-year US Treasury minus the 2-year. Notably, the term premium tends to be at its lowest or even negative before an economic recession. There are more complex versions of the term premium that seek to identify the components driving changes in the term premium. Still, they are highly susceptible to assumptions and provide different answers, so their reliability is suspect.
One measure of long-term expected inflation is the 5-year breakeven inflation rate five years in the future. The calculation isn’t essential, but it is used to measure long-term inflation expectations by removing short-term inflation trends. Investors in long-term bonds should be concerned about long-term inflation rather than short-term inflation. While the US term premium has risen since mid-2023, these long-term inflation expectations haven’t risen appreciably.
Returning to a global focus, the term premium between 30-year and 2-year bonds has risen across all the large developed countries analyzed.
The rise in the US term premium year-to-date does not stand out from the others. Historically, the median US term premium since 1999 has been 78 basis points (0.78%) compared to the current 103 basis points. The term premium has been as high as 399 basis points.
Japan is notable, with a current term premium of 223 basis points and a historical median of 163 basis points. Furthermore, the reading was 269 basis points, so the most current reading is closest to the maximum of any countries considered here. Japan is experiencing a surge in inflation, with consumer prices rising at a 3.6% year-over-year rate after being zero or negative for much of the period since 1999.
Since many factors impact term premiums, it is impossible to know exactly how much concern about fiscal health is being priced into the increase. Circumstantial evidence suggests that bond investors may be growing weary of funding the growing pile of debt without additional compensation.
Conclusion
Although Mr. Dimon primarily spoke about US debt levels and a potential bond crisis here, the decline in the government’s fiscal health is a global issue. In a perverse sense, the US likely benefits from the situation, as it has the extraordinary privilege of a high per capita GDP, control of the global reserve currency, and the ability to issue debt only in US currency. Since the US can handle significantly more debt levels than most other countries, our bond market should be relatively more insulated from crisis. Like any privilege, it can be misused to the point of being revoked, so one must not be blind to the US debt pile.
The current fiscal trajectory in the US is unsustainable, and the debt service burden has grown large enough to squeeze out other spending. The most pleasant way to address the problem is to expand the economy and thereby increase the tax base while maintaining spending at a lower rate; however, it is unclear whether policymakers will choose this path. Though likely apocryphal, optimists will point to Winston Churchill purportedly saying, “Americans can always be trusted to do the right thing, once all other possibilities have been exhausted.”
History is littered with countries choosing to devalue their currency through inflation to repay debts with a cheaper currency, so it is little wonder that term premiums have risen globally. Government bond investors are demanding higher yields on long-term bonds from most countries, which may lead to a shift in the willingness of markets to fund large deficits.
Disclosure: Glenview Trust may hold the stocks mentioned in this article within its recommended investment strategies.
Read the full article here
