Below is the unedited version of my article which was published in the Australian Financial Review in October 2023.

The global bond market is watching the turmoil in the US Congress very closely.  With Republicans in the House of Representatives unable to choose a leader, more and more bond market investors are concluding that US politics-as-usual is incapable of defusing America’s ticking debt bomb.  Only a major bond market crisis will shock the US polity into making the tough decisions needed to right America’s fiscal ship.

The US is neither at war nor in a recession.  Nonetheless, it is running a budget deficit of 7% of GDP with deficits projected to reach 10% of GDP by 2030 and grow from there as the Medicare and social security programs put a greater burden on the nations finances.  If more spending on defence and de-carbonisation is needed then the outlook will grow even more grim.

There is a limit to how much debt any Government can accumulate before a debt spiral begins in which debtholders’ fear of default causes them to demand higher interest rates which then causes higher deficits and more debt and then even higher interest rates, deficits and debt in turn.

A country’s natural debt limit depends on many factors, including savings rates, productivity growth and demographics.  For Japan the limit is very high because its household savings rate is so elevated.  But for the US the natural limit is about 200% of GDP, which on its current course will be reached in about 20 years from now.

That is the recent conclusion of the highly regarded fiscal modelling team at the University of Pennsylvania known as the Penn Wharton Budget Model (PWBM).  Within 20 years the US Federal debt burden will have become unsustainable, with no way of avoiding an actual default or, alternatively, an implicit default in the form of a very long period of debilitatingly high inflation that reduces the debt in real terms.

The holders of long-term Government bonds now face a simple choice.  If they believe that the US has the political will to make the hard choices on taxes and spending that will avert a crisis, then hold on to their bonds.  If not, then sell the bonds today.

Until recently the bond market has assumed that a crisis will be averted, but that confidence has been shaken by the US debt-ceiling crisis in May and June of this year which has morphed into the current Republican leadership crisis.  Moreover, both Joe Biden and Donald Trump are big spenders who have little concern for burgeoning Federal Government debt.

So, long term US Treasury bonds are quite rationally being dumped.  An equivalent statement is that bond market investors are demanding higher yields to hold long term treasury bonds.  The yield on 30 year treasury bonds has risen by a massive 1.25% over the last 3 months, and 10 year bonds by 1.15%.  This is despite the bond markets’ long-term inflation expectation remaining little changed at about 2.50%.

The dramatic rise in yields is not entirely due to the fears about burgeoning deficits and debt.  Natural buyers of bonds, including central banks and commercial banks have withdrawn from the US treasury market for a variety of reasons.  Nonetheless, concerns that the US Federal Government will not mend its tax and spending ways without a major crisis will continue to grow among investors.  Yields will continue to rise until the problem is addressed.

The effects of those rising treasury yields will be felt in every part of the US capital markets and its real economy.  Investors in long duration investments of every kind – stocks, commercial property, corporate bonds, infrastructure and more – will demand higher returns which will send prices down considerably.

Damage to the real economy will be equally large.  The US residential property market has already frozen as 30 year mortgage fixed rates have risen from 3.5% to 7.5% in 18 months.  The US banking system will again be destabilized by even greater losses on banks’ bond holdings.  And, the already large problem of refinancing the debt of companies, commercial property investors and private equity firms that was made when interest rates where far lower will be made worse.  Many things will break.

Australia’s long term bond yields have risen in concert with US bond yields.  However, that linkage will break as time goes on because Australia does not have an evolving Government debt crisis.  Budget discipline is still valued by the Australian public, and long may that last.

2023 is proving to be a year in which many things that were thought to be 10-15 years away are suddenly right upon us.  Think of AI, the slowdown of the Chinese economy and the July-September jump in the average global temperature.  We can now add the beginning of the US debt crisis to that striking list.

Copyright October 2023 Sam Wylie

An edited version of this article first appeared in the Australian Financial Review on 23 October 2023