(Bloomberg) -- Even before talk of fresh unfunded tax cuts took center stage in the budget wrangling on Capitol Hill, US bond investors were making their views loud and clear: If the government keeps spending more than it takes in, there will be consequences.
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Sure enough, one blow landed late Friday, when Moody’s Ratings revealed it had run out of patience and was lowering its credit score on the world’s biggest borrower below the top triple-A level. It cited a years-long pattern of rising debt and budget deficits, which show no sign of abating amid deeply-rooted political polarization.
While the Moody’s decision was anticipated given the flood of red ink in Washington, and it trailed moves from the likes of S&P Global Ratings, investors responded by lifting the yield on US 30-year bonds above 5% for a time on Monday to the highest since November 2023.
That reinforces what many in financial markets have been highlighting: Unless the US gets its finances in order and soon, the perceived risks of lending to the government will increase, and borrowing costs on long-term Treasury debt will climb even further. That would make reducing the deficit even harder and lift the cost of money for households and companies throughout the economy.
“This is a reminder that it is expensive to kick the fiscal can down the road,” said Priya Misra, portfolio manager at JPMorgan Asset Management, after the downgrade on Friday.
The yield on the 10-year note is up about a third of a percentage point this month alone. Embedded in the market is a rise in the premium investors demand to shoulder the risk of owning longer-term US debt. But even shorter-term securities due in two years or less are yielding more than 4%.
“The bond market is skeptical that the Trump administration and Republicans will offset some of the deficit challenges,” said Michael Arone, chief investment strategist at State Street Global Advisors. What this means is that “rates will remain higher and more volatile” than some investors currently expect, he said.
Markets have a history of being the arbiter of fiscal discipline for spendthrift countries, and the recent spike in yields is beginning to echo past instances when so-called bond vigilantes wielded their power in protest of profligacy. The theory goes that if investors impose higher borrowing costs, governments eventually bow to the pressure and retrench.
This time, though, the stakes are much higher. Even though America’s premier position in global finance is still secure, the government faces less borrowing flexibility at a time when international demand for Treasuries — and the US dollar — is increasingly in doubt.
Moody’s flagged a decline in “debt affordability” and identified higher Treasury yields as a factor hurting US fiscal sustainability. A walk through the numbers reveals what it means by this concept, and explains why doubts around the sustainability of US debt have become a regular talking point among investors, central bankers and financiers from Jamie Dimon to Warren Buffett.
While current US yields between 4% and 5% are near levels that prevailed before 2007 and the financial crisis — and the US historically has paid far higher rates at times — debt and deficits now are exponentially bigger, and that makes all the difference.
A then-and-now look at the fiscal landscape since 2007 reveals a staggering transformation. The amount of outstanding Treasuries has skyrocketed from $4.5 trillion to nearly $30 trillion today — a reflection of the explosion in borrowing during Covid. Annual gross sales of government debt have also ballooned, from $362 billion in 2007 to $2.6 trillion last year, according to Sifma, the bond market’s trade group.
More alarmingly, the ratio of total US public debt to the size of the economy has risen from about 35% in 2007 to 100% now, according to the Congressional Budget Office. Interest payments alone were about $880 billion in 2024, CBO data show.
Enter the budget talks, and a deficit in the trillions running at 6.5% of the economy appears entrenched as tax cuts backed by President Donald Trump loom in Washington’s latest spending plan without sufficient offsetting cost cuts or revenue to pay for them. Trump is pushing for the budget bill’s passage even as hardline Republicans bristle at the prospect of wider gaps.
“The current plan that they’re putting forward is not going to make a material reduction in the deficit in my view,” said David Rogal, portfolio manager of fundamental fixed income group at BlackRock Inc. and a member of the Treasury Borrowing Advisory Committee, an elite group of bond market participants. “The funding gaps open up next year and the year after, where there’s close to $2 trillion if the deficit stays on its current course. How we deal with that is going to be very important.”
The precarious nature of the situation isn’t lost on US Treasury Secretary Scott Bessent, who acknowledged to US lawmakers earlier this month that the nation’s debt path is unsustainable. He also indicated an awareness of the power of the bond vigilantes, adding it’s “very difficult to know” the tipping point at which investors would “rebel.”
As for the downgrade, Bessent told NBC’s Meet the Press on Sunday that “Moody’s is a lagging indicator — that’s what everyone thinks of credit agencies,” and lambasted the spending under the Biden administration.
But Moody’s said its action reflected not just excessive spending during successive administrations, but a bleak outlook for the fiscal picture and the expectation for “larger deficits as entitlement spending rises while government revenue remains broadly flat.”
Without political will to rein in spending in a meaningful way, and no guarantee that tax cuts will goose the economy enough to allow the government to grow out of its debt problems, Bessent will have to hope that a tipping point into rebellion doesn’t occur anytime soon in the bond market.
Already, there have been rumblings from investors like Eurizon SLJ Capital’s Stephen Jen that a bond-market blowup may be needed to force real progress on fixing the budget.
What Bloomberg Strategists Say...
“Moody’s decision underscores deeper structural concerns. The risk is that bond vigilantes re-emerge, pushing yields higher as term premiums adjust to the new fiscal reality. That could weigh on equity valuations and rekindle broader doubts over the resilience of US assets.”
— Mary Nicola, Macro Strategist
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In the meantime, the Treasury is walking a fine line as investors grow wary of taking on long-term securities and are turning instead to debt with shorter maturities. For an agency that seeks the lowest financing cost over time and extols a regular and predictable approach, the response has been one of selling more short-term debt, where there is better demand.
“It’s a very delicate balance between how much you can issue further out in the long end relative to demand,” said John Madziyire, senior portfolio manager at Vanguard. “And I’ll say that’s one of the things that limits how far out the Treasury can issue.”
Bessent has maintained the same debt mix as his predecessor Janet Yellen, who moved toward selling more bills following a bond-market tempest in late 2023. That has lowered the average maturity of the government’s IOUs. The result: increased hazards around smoothly rolling over big amounts of debt as it comes due, especially in another debt-ceiling standoff scenario, and a situation that creates a point of vulnerability.
“The more you have to roll over and the more politicized the debt ceiling is, the more risk you’re putting into the system,” said Greg Peters, who helps manage more than $850 billion as co-chief investment officer at PGIM Fixed Income and is also a TBAC member.
Of course, the US is unique compared with other countries in having a vast money market industry rather than relying on bank savings accounts. The current stash of nearly $7 trillion in these funds means there is a regular buyer of Treasury bills that extends from four weeks to 12 months. That funding mix provides Treasury with a lot of wiggle room, but the longer Treasury yields remain in a 4%-plus zone, the cost of rolling over a growing debt pile keeps rising.
“Now Scott Bessent’s Treasury Department is funding short rather than long and you have huge refinancing obligations,” James Millstein, co-chairman at Guggenheim Securities and a former US Treasury official, told Bloomberg TV on Monday.
The debt problem and the expectation among watchdogs including the CBO that US entitlement spending will only shoot higher in the years ahead leaves the Treasury with little choice but to retain its current funding mix and wait for a window of lower longer-dated yields.
“Ultimately the issuance strategy can help, but the big picture will depend on whether the budget deficits themselves are improving,” said Guneet Dhingra, head of US interest-rate strategy at BNP Paribas.
For now, the US has still has scope to manage its debt should lawmakers continue to run up deficits. An investor standoff that forces a yield surge beyond 5% would likely encourage other long-term natural buyers such as pension funds and insurers to step in. Even in the case of an unruly rise in bond yields or messy auction, market participants said it’s likely that the Federal Reserve would intervene and buy Treasuries as a backstop.
“If you had a really sloppy auction, say a 30-year or 10-year, and the bond market really got unsettled, then I think at that point the Fed would probably step in,” said Jurrien Timmer, director of global macro at Fidelity Investments. “It’s part of the Fed’s job to maintain orderly markets.”
Zooming out from a historical perspective, though, the US has already breached a worrisome threshold. Historian and former Bloomberg Opinion contributor Niall Ferguson cites a different type of tipping point: When the cost of paying interest exceeds US defense spending, that puts a great power’s influence in jeopardy. This already happened in the US last year.
“Debt is a problem, but you know, what is even more of a problem is not addressing it,” said Sinead Colton Grant, chief investment officer at BNY Wealth.
--With assistance from Ye Xie.
(Updates prices; adds commentary in the 26th and 28th paragraphs.)
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