It is common for governments to only address deteriorating public finances when they are faced with a debt market crisis. However, the recent withdrawal of central banks from sovereign bond markets could potentially lead to a showdown.
Despite market concerns about the increase in Western government debt since the COVID-19 pandemic, there has not yet been a significant investor backlash. While bond prices have been impacted by global inflation and rising interest rates, they have been adjusted in an orderly manner based on official rate parameters.
With the exception of a brief period of market stress in the UK, there has been little sign of distress in US or euro zone debt markets, and the risk premiums for holding longer-term debt remain low.
It seems that the markets may be assuming that the inflation and interest rate turmoil is over, as they have not demanded higher compensation for funding larger deficits and national debt burdens.
However, the International Monetary Fund (IMF) has once again warned about the lack of action on excessive spending and budget deficits, particularly in the US - the country with the world's largest government bond market.
The IMF has expressed concern about the US's fiscal stance, which they believe is not sustainable in the long run. This is especially concerning considering the pivotal role that the $27 trillion Treasury market plays in global borrowing costs.
The numbers speak for themselves - according to the Congressional Budget Office, US government debt is expected to reach a record high of 107% of national output by the end of the decade and over 150% in 20 years, based on current budget and interest cost projections.
Despite this, the bond market has remained relatively calm, even with the increasing number of quarterly sovereign debt sales. This is remarkable, considering that the New York Federal Reserve's estimate of the 10-year "term premium" - the additional compensation demanded by investors for holding longer-maturity Treasuries - is close to zero.
This is 150 basis points lower than the 60-year average and 35 basis points lower than the 16-year average that includes the Fed's bond-buying balance sheet expansion.
The hope for interest rate cuts by the Fed this year has also played a role in supporting bonds, even as the Fed continues to reduce its holdings of Treasuries that were acquired during the pandemic.
While the Fed may discuss slowing down quantitative tightening at its upcoming policy meeting, there is currently no indication of it stopping completely, let alone resuming bond-buying. And the Fed is not the only reliable buyer that has gradually stepped away - other central banks around the world are also doing the same.
Treasury tsunami?
According to Barclays' annual Equity Gilt Study, this gradual withdrawal of central banks from bond markets will lead to investors becoming more cautious in pricing the surge in government debt.
The study also dismissed some of the more alarming scenarios, such as a sudden halt in demand for US Treasuries or a significant decline in the dollar's status as a reserve currency.
The buyer base of U.S. Treasuries has slowly been shifting away from price-insensitive investors, such as foreign central banks, which ‘need’ to buy government bonds, to price-sensitive ones, such as the domestic household sector, which ‘chooses’ to buy them
Barclays annual Equity Gilt Study
However, it does warn that the combination of unchecked budget deficits, high and volatile interest rates and inflation, as well as a reduction in "price-insensitive" bond holders such as central banks, could lead to a larger market adjustment.
It also notes that the buyer base for US Treasuries has shifted from central banks to price-sensitive investors such as households and hedge funds.
This shift is expected to increase term premiums to a more sustainable level, which in turn will lead to higher borrowing costs.
The study also predicts that fiscal dynamics will worsen, leading to increased Treasury volatility, which will have various effects on the market, including undermining the argument for holding bonds as a diversification strategy for stocks.
Additionally, the Fed's current view of a neutral policy rate of 2.6% may increase over time due to the persistent US deficit-related stimulus, which could reach as high as 4%.
This could also lead to higher long-term borrowing rates and a positive Treasury yield curve, regardless of whether the Fed sharply cuts rates or not. If investors struggle to absorb the increasing amount of debt without a change in fiscal policy, Barclays believes that there could be trouble ahead.
The study concludes that the Treasury market has become too large, and investors must consider the potential for increased illiquidity, poor functioning, and higher volatility when valuing bonds. Whether this will be enough to force a change in Washington's thinking after the election remains to be seen.