There has been a large increase in interest rates on government bonds. The focus has been on the supply of debt. An even more important factor is the size of the debt and the future size of the debt. The economic returns for holders of long duration U.S. debt do not look very good.
The major holders of U.S. long term sovereign debt are the Federal Reserve, other central banks, insurance companies, commercial banks, and federal, state and local pension plans including the Social Security and Medicare funds. These entities hold U.S. debt for non-economic reasons. For instance, the Fed has been reducing its holdings of government debt at a rate of around $60 billion per month along with large reductions in its holdings of mortgage-backed securities “MBSs”. This is a reversal from its previous large purchases: its policy switched from quantitative easing to quantitative tightening. This change was not driven by a view about the returns from holding treasuries but rather from a change in whether the Fed wanted to stimulate or dampen aggregate demand.
At the same time as the Fed has been lowering its holdings of treasuries and the MBSs the federal government has been issuing more debt to fund its deficits. Thus the non-traditional holders of government debt have to be induced through higher interest rates to hold more of the debt. However, it is the cumulative stock of government debt held by the non-traditional debt that affects their capacity to hold that debt. Initially, the imbalance between the supply and demand for treasuries could clear at negative real interest rates. But as the buyers at negative or close to zero real interest rates hold a larger fraction of their assets in treasuries, they will demand increasingly higher real interest rates to hold more treasuries.
The agents who are going to be the buyers of treasuries in the future are increasingly going to be motivated by economic factors such as the future capital gains and losses on their holdings of Treasuries–those expectations of capital gains and losses will be influenced by expectations of future inflation but also by expectations of how future net issuance of debt will affect interest rates. Over the course of the next 10+ years the federal government debt as a fraction of GDP will be growing significantly, the Social Security and Medicare Trust funds will be eliminating their holdings of U.S. Treasuries; foreign central banks show no signs of wanting to increase their holdings of U.S. Treasuries and may reduce them if there are further downgrades of the U.S. credit rating. The Fed could switch from quantitative tightening “QT” to quantitative easing “QE”, which would involve buying government bonds. Its aim is to keep inflation at an average level of 2%. The core PCE which is the measure the FED uses for inflation is likely to grow as the prices of medical services adjust to the increased cost of providing those services. The fall in new starts of housing units and the fall in permits seem likely to drive an increase in rents, and fiscal policy seems likely to remain somewhat expansionary especially if the popular increases in the standard deduction in the 2017 tax bill that expire in 2025 are extended. Even if there is a recession in 2024 it seems more likely than not that we will see continued inflation over the next 10 years.
All these factors will be increasing the amount of government debt that will need to be held by economically motivated actors. As the stock of their holdings increases their risk exposure to increased in long term increases in interest rates increases and the interest rates they will demand to hold Treasuries will increase. To induce new holders such as hedge funds or actively managed mutual funds to hold more long-term Treasuries rather than investing in equities or corporate debt very high real interest rates may be needed.[1]
The higher interest rates on U.S. debt will also impact the interest rates on investment grade corporate debt, on municipal bonds and on the interest rates on mortgages and auto loans. I would be cautious about buying long duration debt.
[1] Our astute readers may be thinking that Japan has been able to greatly increase its net supply of government debt without an increase in long term interest rates. The Japanese story has to be taken in the context of a stock market that fell from around 39,000 to 7,000 in the space of a few years, and real estate market that also suffered massive losses after 1990, as well as a banking crisis in 1995. These crises caused the households to put their savings in the postal bank which holds government debt and for Japanese corporations to have very high savings rates which are keeping interest rates low across the entire yield curve.