Two things dominated the Treasury auctions and secondary markets this week. The first was the reversal of the trend of rising yields. It started with clear signs of stability in the market, with weaker upward pull from the secondary market on auction yields.
Some maturities auctioning at lower yields this week than at previous auctions. On Thursday, this upended the relationship between auction and market yields. For several maturities, market yields are now lower than their last auction yields, which could indicate modest reductions in yields at coming auctions. If this holds over time, it is good news for the Treasury, but even if it doesn't, this reinforces the trend we have been pointing to, namely that yields on the U.S. debt are stabilizing.
Stabilizing interest rates is a sign of growing investor interest in U.S. sovereign debt. One reason is the slow but continued drop in inflation. High inflation lowers real interest rates, eventually flipping them negative, which benefits debtors over creditors. This forces investors to pursue higher-yield opportunities, driving the Treasury to raise interest rates in indirect response to inflation. Now that we have four months in a row with declining inflation, it is only reasonable that the real-rate pressure on Treasury yields also weakens.
Continuing increases in inflation in Europe could reinforce this trend, as investors see a combination of improving returns on low-risk U.S. Treasury securities and the dollar strengthening from lower inflation.
While it is good news that interest rates seem to be reaching their peak, there is still bad news out there for the Treasury. Which brings us to the second big news from the Treasury auctions and markets this week: the rising cost of debt rollover.
The U.S. Treasury currently sits on a total of $2.5 trillion that:
- Matures in the next 12 months,
- Is of all maturities 10 years and less, and
- Costs the Treasury one percent or less in interest.
If this debt is rolled over into new debt at four percent interest—a likely rate today—and if this rate prevails throughout the fiscal year as short-term debt continues to roll over, then Congress will have to appropriate another $87 billion per year, just to pay for the increase in interest on these $2.5 trillion.
This is just the cost for the cheapest segment of the federal debt. As an example of how rapidly the cost of this debt is rising currently, on Wednesday the Treasury sold $47.3 billion in 10-year notes. It replaced a batch of $24 billion in maturing debt, on which the Treasury paid 1.63 percent interest. The newly auctioned volume costs a median yield of 4.044 percent.
In other words, this auction alone increased the annualized cost of the federal debt by approximately $1.5 billion. In total, auctions this week raised the annualized cost of the debt by $4 billion.
Let us note what the term "annualized" means: it is an estimate of what the increase in debt at a given auction would cost the Treasury, should the median yield from the auction remain unchanged in coming auctions for the rest of the fiscal year.
With this in mind, it is important to note how serious this trend in rising debt costs is, and what few options there are for it to come to an end:
a) The Treasury starts paying down the debt;
b) There is unprecedented interest in U.S. debt from investors; or
c) The Federal Reserve reverses its current monetary policy.
Alternative c is highly unlikely, given the unanimity of the Federal Open Market Committee behind the current policy. Alternative b is more likely, but not with the same force as we are seeing currently. The reason for this is simple: if the U.S. economy goes into a recession—even a mild one—it will negatively affect the currency. A weakening of the dollar eats into the gains of foreign investors, giving them pause before putting more money into the U.S. debt market.
Alternative a is the most likely route to bring about a decline in auction and market yields. Yields may still remain stable even in lieu of debt paydown efforts, but if they only remain stable around the four-percent level, our forecast of sharply rising debt service costs remains valid.
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We do not give investment advice.
This blog provides analytical information solely for the purposes of 1) predicting the cost of the federal debt, and 2) for assessing the risk for a U.S. fiscal crisis. All information published here, forecasting and other, is based on publicly available data from the U.S. Treasury, including but not limited to approximately 65 percent of the current debt; on macroeconomic data, including but not limited to monetary policy decisions by the Federal Reserve; and on macroeconomic theory.
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