Those Bond villains got it so wrong. All the time and energy they spent trying to control the world through complex and nefarious schemes involving laser beams, atom bombs, Fort Knox gold, exploding satellites and whatever the malefactor was trying to do in that stupid ice palace in Die Another Day (Pierce Brosnan, what were you thinking?) was a complete waste. All they really had to do was suborn the bond market.
Mr. Carville, one of the unsung philosophers of early 21st Century America, is credited with the quote, “I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter. But now I want to come back as the Bond Market. You can intimidate everybody.”
He was right. The bond market sold off violently after so-called “Liberation Day” and all of a sudden everyone noticed that if the US Treasury market began to wobble, all sorts of really horrible things would happen. It was so obvious and the consequences of a bad outcome were so dire, even the White House paid attention. They negotiated a nifty U-turn (without admitting, of course, they had done so) and the bond market relented. The market rewarded that burst of sensibility by buying bonds again.
The interesting thing is that the selloff wasn’t actually caused by the tariff threat, it was simply triggered by it. Investors rapidly concluded that the threatened tariff war was not apocalyptic. No unsustainable tit-for-tat tariffs that would shake the global economy to its very foundation was on offer. Messrs. Smoot and Hawley could take a deep breath, their exalted place in the history books is safe.
Yet the Treasury market continues to look vulnerable.
The market sold off because Liberation Day unwittingly focused everyone on the broader state of the US economy, the consequences of Mr. Trump’s Big, Beautiful Bill and our huge and burgeoning deficit. It’s not that we didn’t know it was there, it’s just that we weren’t looking at it. Ever go to one of those corporate navel gazing exercises where you were forced to watch a bunch of kids bouncing a basketball and were instructed to count the number of times the basketball was passed back and forth in 60 seconds? Did you notice the dancing gorilla? The vast majority of the audience (a nice way of saying…me) didn’t (and oh, by the way, we made them play back the tape to make sure they weren’t fooling us and inserted the gorilla after we finished watching. Nope, we saw, but didn’t see).
Our screamingly large and growing deficit is our gorilla, and indeed we only notice it when we decide to notice it. Trouble is, eventually we are likely to.
Having finally really seen the gorilla, I’ve recently worked myself into a lather over the deficit and the growing overhang of public debt. We really ought to do something about it before, well before something goes horribly wrong. We won’t, of course, but whinging about it makes me feel a wee bit better.
So, I go on.
The scale of the US debt is astonishing and it matters. We’re running about $2 trillion a year and the aggregate federal debt is pushing $40 trillion and likely to grow. For the moment, let’s not even talk about burgeoning state and local debt ($4 trillion), the almost $2 trillion of dodgy student loan debt, nor the implied guaranty of the Twins’ aggregate debt which amounts to over $7 trillion. Let’s also give the Fed’s attachment to its huge and continuously growing balance sheet and ownership of 20% of US debt a pass…just saying.
The proposed Big, Beautiful Bill Act (yes, that’s actually its formal name) is not the whole problem, not even the biggest part of the problem, but it’s surely not helpful and it serves, at the moment, as a poster child for our political leaders’ dissolute behavior. Neither party is able to control the growth of our deficit. There are, regrettably, no adults in the room. For heaven’s sake, the Republicans, the party of alleged financial rectitude, just barely managed to embrace a tiny little $9 billion recission bill. This undisciplined and economically careless behavior will matter. It will matter sooner or later (but sooner is a real risk) for our status as the world’s reserve currency. It will matter for the cost of our government’s debt (which is already costing as much as our entire defense department’s budget). It will matter for our government’s ability to respond to economic stress and it will matter for private borrowing…A LOT.
I get it. I understand. One might say that our gloriously elected representatives lack the courage to do the right thing and that may be true, but on the other hand, one might observe that we have simply failed to understand what we elected. What we miss, election in and election out, is that each and every one of them understands with perfect clarity their most important job: Getting re-elected. That’s their job, just like you and I have a job. If great legislation, or masterly management of the government itself happens, it’s sort of a positive externality to be cheered but hardly to be expected.
Courage and re-election these days are entirely incompatible. In the “old days,” sometimes, the slightly left and the slightly right of center periodically got together to get stuff done and agreed not to assault the other for compromise. Not anymore. You don’t even get to talk compromise with the other side of the aisle because to fail the test of perfect fidelity to one’s core constituency is to get savagely primaried by the base and…not re-elected. The middle has been hollowed out.
As some wag observed, the electorate likes Democrat spending and Republican tax cuts and our gloriously elected representatives all know that, and they deliver. We get lower taxes and more spending. There is absolutely no shame, even as our politicians actually know in their heart of hearts where this is going. It’s rather like the story of the scorpion and the frog; it’s in their nature.
Regardless of what happens to the Bill, our journey into Greek-like (modern, not ancient) debt to GDP seems inescapable. (Sure, if the country magically achieves a 3% GDP growth rate for the next decade or so and stops deficit growth now, there may be some hope, but there is precious little reason to expect that to happen, is there?)
In comparison to the growth of the deficit, almost everything else that happens in Washington is, at some level, either not helpful or noise. Yes, we are having a brief hurrah for reduced inflation right now and the Fed is taking a victory lap for controlling the short end of the curve. That’s good, but not consequential for the real cost of keeping our economy healthy and robust. We can pass some legislation and embrace some policies which, standing alone might be good (I do love SALT), but they all pale into insignificance compared to the deficit problem. You know, the one that no is paying any attention to.
Is this a critical today problem? Probably not. Is the US status as the world’s reserve currency at risk right now? Not yet but, just ask the Brits what happened to them between 1914 and 1945. They didn’t see that coming, did they? Their banishment on the international stage to the kids table has been a big part of what’s been a decades long drag on their growth (okay, Brexit didn’t help but that was never the main thing).
What Hemingway said about bankruptcy will be absolutely true for our fiscal mess. “I experienced bankruptcy two ways; first slow and then fast.” We’re still in the slow phase, but you never know when the fast bit will begin.
As I’m writing this, the Treasury market is holding up reasonably well. The ten year has crept down after threatening the emotionally important 5% level, and the Treasury has had a couple of decent prints. Policy types are high-fiving over each new and slightly better inflation print. Cut rates! Get the candy bowl back on the table. Enough of this austerity nonsense!
We’re all aflutter because economic prospects don’t seem as awful today as they did a couple of months ago. In response, transactional activity across a range of markets is picking up, people are marinating in the sugar high wave of relief following the end of the tariff tantrum.
The central risk confronting our economy remains unchanged and unaddressed. This is, in a sense, a bear market rally. The cost of the US government is not going down under this or any other administration. The cost of US debt is not going down. It will inexorably grind higher. It’s just simple math. Maybe we’ll engineer a retracement of the short end of the curve for a bit, but Fed shenanigans can’t fix the long end which is all about supply (too much) and demand (too little). You think it might matter out there if the federal deficit exceeds 120% of GDP? 150%? More?? Note that 120% is a higher share of the economy than debt represented during World War II. Do you think anyone out there in the bond market might notice?
There’s only one real question: When will they notice? What they will do about it is not. When the dancing gorilla is finally noticed, a repricing of government debt, which could be savage, will happen. Note it’s not dependent upon some new black swan, some new really bad and completely unexpected event occurring. The facts on the ground right now could surely be sufficient reason to reprice our Treasury securities. Market participants could conclude tomorrow, they could conclude a month from now, or they could conclude years from now, that there is a compelling case to shed Treasury’s exposures and demand considerably more to hold our government debt. It’s very likely to happen (like a good economist, if I’m telling you what, I’m surely not telling you when). However, if I had to put a dollar on whether the ten year would have a three handle or a six handle by 2027, I’m taking the over.
What would that world look like? Initially, materially higher borrowing costs and real inflation, plus reduced growth. You know, stagflation. A severe recession will follow. Risk assets will have to be repriced. GDP growth will slow and reverse. Employment will suffer (even without help from AI). We’ll have a government at that point handcuffed by circumstances with little dry powder to kickstart recovery and our economic life will not be terrific for a considerable period of time. If we were to stomp on the fiscal and monetary gas pedals (and we probably will), we need to remember there’s little in the tank; these initiatives would only make the core problem worse. I was recently in Greece and what one sees is the carcass of their economy horribly scarred and barely showing much of a recovery from the Greek debt crisis which is now 20 years ago. Not pretty, but of course, we’re not Greece, but if our reserve currency status is in trouble, we’ll no longer be entirely immune to Greek-like problems.
I don’t mean to be a breathless Cassandra (or, well, maybe I do). I’m not expecting anything horrific to happen soon. Generally speaking, continuity trumps disorderly, rapid change. Existing conditions are remarkably persistent even when stressed. However, at some point there is a real risk the growing deficit will trigger a debt crisis. Is it inevitable? No, maybe like the best house on a bad street, we can go on and on with breathtaking levels of debt indefinitely without consequence. Do we really want to make that bet? The answer, of course, seems to be yes, we do and we will.
How should private market participants play this reality? Good question. If things really go castors up, our markets will adapt, as we’ve adapted to higher interest rates and slow growth in the past, but don’t mistake the fact that a butcher’s bill will be due and will need be settled. Transactional activity, commercial real estate values, and growth, will be suppressed for a considerable period of time. Deleveraging will be the watchword for markets for as far as the eye can see. That cash-in refi, already common, will become a constant companion to any refinancing. If you think we have a bad legacy asset overhang problem right now, just wait for what happens when the yield curve shifts up materially and then stays elevated while the value of all risk assets plummets. There must be something we can do about this…right? Waiting for the adults to return to the room and actually do something about the problem seems to be a forlorn hope. Bill Clinton fixed it 30+ years ago, but the preconditions for that type of fix are simply not present now, and God help me for saying so, there’s actually no Bill Clinton out there to step in and do the right thing.
All we can do is operate our businesses with the certain knowledge that economic conditions may materially worsen, and it may happen at any time. For sure, it’s going to feel like a thunderbolt out of the blue.
What does one do? We certainly can’t just grab the go-bag, climb into a hole and pull it in behind us. Things are surficially okay right now. There’s money to be made, opportunities to be embraced. The bad things might not happen for quite a while. As a famous CEO once said following the GFC, as long as the music is playing, we have to dance.
Yet, some defensive steps can be taken without going into a full metal jacket defensive crouch. First, start looking for tells that conditions in our Treasury market are eroding. While I still suspect that when it happens it’ll be a surprise, that’s not a reason to tune out and disregard warning signs. Don’t assume that upward yield creep is a random event. Look hard at whatever all you people who are smarter than me look at to assess the health of our debt markets. Be vigilant.
I’d sure be looking to finance more assets with long term fixed rate money (notwithstanding the loss of optionality). I’d certainly not invest for perfection and keep some powder dry. I would shorten duration and be more willing to take profits when offered. Don’t overpromise returns to investors. Be frank and transparent about the macro environment. Let’s not recapitulate the yield-chasing trade against the iron realities of the future path of our macroeconomic environment. If I’m a bank, I would leave a little cushion in my capital levels. If I’m a portfolio lender, I would begin to chip away at my warehouse exposure and do my best to move assets into CRE CLO type structures where I can lock in my cost of funds (even if that cost of funds is less attractive than might be available in the warehouse market today). We should do something, shouldn’t we, to get ready for the tempest? Look, all this might not happen, or it might be so remote in time that effectively it can be ignored in the here and now. I’d be delighted to be wrong about my assessment that the risk embedded in our deficit spending feels more likely than not and may begin to matter rather annoyingly soonish. Remember, one fixes the roof before the storm arrives.