This week's Treasury markets and auctions confirmed that interest rates on U.S. sovereign debt has stabilized around the four-percent mark. Long-term yields declined somewhat, with the 20-year bond dropping at auction from 4.319 percent in October to 4.01 percent. This is the biggest yield drop on record since at least the beginning of FY2023.
The coming monthly auctions in the maturity spectrum from one to five years will have a major impact on the average cost of the debt. This past week, that average cost has remained steady at 2.06 percent, but prior to that the cost increased by almost 0.01 percentage points per day from November 1 through November 11. Furthermore, from October 14 to November 14, total U.S. debt increased by 0.34 percent, but the annualized interest-rate cost increased by 7.8 percent.
This sharp discrepancy will not continue, but the cost of the federal debt will continue to rise. We have pointed in the past to the debt-cost shock that is coming, as a result of cheap debt being replaced by more expensive debt.
A nightmarish scenario for Congress would be one where interest rates continue to rise, and therefore push the debt cost further upward. This is unlikely; a more probable scenario is one where rates stabilize in the four-percent vicinity where they are now. However, even as things are now, Congress is looking at a total cost for the U.S. debt over this fiscal year that matches the expected cost of Medicare.
One reason to believe rates will not go up further, especially not in the short run, is that inflation is now subsiding. We reported previously about consumer price inflation stabilizing; this week saw a sharp drop in producer-price inflation:
Figure 1
Source of raw data: Bureau of Labor Statistics
As a general rule, changes in producer prices precede changes in consumer prices by two months. The top in consumer-price inflation in June can be explained by the stabilization of producer-price inflation in the spring. The drop in PPI inflation since June will therefore translate into declining CPI inflation into the first quarter of 2023.
With inflation subsiding, there is less pressure on real interest rates. This, in turn, shifts the balance in credit markets back toward lenders; when real interest rates are negative, debtors are the relative winners vs. creditors. That is not a sustainable situation over time, but can—if protracted—cause a financial crisis. We have not seen a tendency toward that during this inflation episode, but the Savings and Loans crisis in the 1980s could in part be traced back to the stagflation years in the late 1970s and early 1980s. Therefore, it is very good news that we can expect real interest rates to improve in the coming months.
There is one factor that may weaken the positive effects of subsiding inflation. The U.S. dollar rally vs. European currencies that began in the spring, has come to an end. There is a fair chance that the dollar will weaken in coming months, especially against the euro, the sterling, and the Swiss franc. If so, import prices are going to push upward, which would include oil prices. While the effect on oil prices on U.S. inflation is limited (though not insignificant), it still has the potential of watering down the positive effects from the inflation trend reported above.
Looking at the next six months, the case for a weaker dollar is stronger than the case for further appreciation. Substantial amounts of foreign money has been invested in U.S. markets during 2022, and many investors may want to cash in on those profits. The combination of higher interest rates in the sovereign-debt market and a rising dollar vs. their home currency, can make for substantial gains.
However, if the dollar does weaken, the investor cash-in effect will not be substantial. The major worry is if Congress does not take a proactive position on its rising debt costs. If the projected interest-rate payments on the U.S. debt run high enough to become the second-costliest item in the budget (a realistic scenario), and if Congress is perceived as reacting with panic or indifference—both of which would be equally bad—then the debt market can take this as a signal that the legislators are not going to prevent a possible debt default.
If we get to this point, we will see both market and auction yields on U.S. debt rise toward ten percent. That would be a highly unstable situation from an economic, political and social viewpoint, especially on the heels of our current inflation episode.
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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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