What Does the Bond Market Want From Washington?

Deficit alarmists worry that if the U.S. government doesn't get its runaway spending under control, it will end up just like Greece. If the bond market starts worrying about a U.S. default, that would drive Treasury rates up, and make it even harder for Americans to dig themselves out from their national debt. But at this point the bond market doesn't seem to mind the astronomical deficits: Treasury note interest rates remain incredibly low -- and have fallen more than 100 basis points since April. This prompted Stan Collender to assert in his Roll Call column this week that the bond market is actually calling for an even bigger deficit and more economic stimulus. That might be taking the logic a bit far.

Here's the heart of Collender's argument:

It's almost impossible not to notice how unambiguously the bond market deficit cheerleaders are making their policy preferences known. In spite of the repeated prognostications made by multiple commentators that interest rates will (rather than could) rise in response to the large deficits because of bond market disgust, traders have voted with their dollars. The auctions of Treasury securities that were needed to finance borrowing have almost all demonstrated a strong demand for federal debt over the past year, no matter what the maturity. As a result, interest rates have remained low or fallen. This is especially the case with long-term rates, which would be the ones most affected by concerns about budget-related federal borrowing and inflation. The bond market deficit cheerleaders have shown little indication they're concerned.

And in case you want proof, here's a chart of the 10-year Treasury note yield curve since 2009:

10 year treasury yield 2010-08.PNG

First, Collender is right about one thing: the bond market doesn't appear particularly convinced that the U.S. will have trouble paying its debt over the next few decades. But there are a number of other factors that are driving down interest rates other than investors' purported love of deficits. One big one includes a flight to quality as the equity market retreated in the second quarter and global debt became less attractive due to sovereign crises abroad. With firms and banks hoarding cash, they demand additional safe, liquid assets that will earn them some income, which also drives down Treasury yields. To his credit, Collender notes these are potential explanations as well, but then says that investors could still look elsewhere if they were scared of U.S. debt.

That's true, but where else might they look? If you're a bond investor, you don't have many particularly good options right now. The asset- and mortgage-backed bond market is pretty weak these days, with limited new supply as Americans borrow less. Agency debt is no better than Treasury notes with the nationalization of the GSEs. Municipal bonds are viewed as riskier than federal debt as many states struggle with their budgets. Corporate unsecured debt is certainly risky given the uncertainty that faces firms at a time like this.

Investors could hold cash instead, but then, will there be inflation or deflation going forward? Again, there's a lot of uncertainty there. But a U.S. default? Come on. Bond investors are still content with Treasury notes because there aren't many better alternatives for low risk investing right now.

Yet it's hard to really understand the jump Collender makes from saying that bond investors are grudgingly tolerant of current debt levels to saying that they want even more federal debt to provide for additional stimulus. One could alternatively argue that the recent austerity pressures and deficit reduction rhetoric coming out of Washington might please bond investors. They could believe that policymakers have deficits on the brain, so they won't let things get too out-of-hand. After all, for some months now, it's been pretty clear that another massive stimulus bill probably isn't going to withstand the political process. Congress could barely even pass something as uncontroversial as unemployment extensions.

The only way to really substantiate a claim like Collender's is to ask bond investors this question directly. What would be interesting to see is a poll asking Treasury note buyers if they would prefer, in the near-term, to see the U.S.: a) stay on its current (though ultimately unsustainable) deficit path; b) aggressively provide more economic stimulus and widen the deficit; or c) begin austerity measures immediately. Collender argues for b), but a) seems far more plausible. The U.S. isn't in any imminent risk of default, but tightening fiscal policy could result in a double-dip. It might be possible that bond investors would think even more stimulus could be provided without having to worry much about a U.S. default, but that's different than saying they want it.