US bond yields rise as reserve currency status declines

With much dismay, financial market participants watch U.S. Treasury yields rise as Jerome Powell and the Fed continue to lower the federal funds rate in an effort to spark a new wave of easy money.

The Fed Funds rate is a short-term interest rate used for interbank borrowing. U.S. Treasury bonds are medium- to long-term securities that represent the sovereign debt of the U.S. government, so the yield on these bonds represents the U.S. government’s cost of borrowing. Although there is no law linking the two, the Fed’s rate cut generally results in lower Treasury yields.

Explanations for this discrepancy have been offered, talking heads have spoken out, and conclusions abound as to the meaning of the movement. Given these mixed signals, difficult questions related to the financial health of the U.S. Treasury arise. Is government overspending finally catching up? Isn’t the Fed’s increase in easy money a reckless and inflationary bet? Is global reserve currency status a curse rather than a blessing?

Regardless of what happens with U.S. bond yields, these are important considerations for an American public ravaged by inflation due to government overspending and continued monetary aggression from the Federal Reserve.

Deficits of 2,000 billion dollars

The United States is on track to run a $2 trillion deficit this fiscal year, which began in October. This will be on top of the existing national debt of $36 trillion, or 135% of GDP. Despite the ridiculous rhetoric from the Department of Government Effectiveness, all signs point to continued large deficits under the Trump administration. The recent evolution of American bond yields does not help the situation.

By August of this year, futures markets had fully priced in a Fed rate cut of 25 to 50 basis points in September and were expecting additional 25 basis point cuts in November and December. This expectation for the Fed Funds rate was initially reflected in Treasury yields. In early August, as markets expected the Fed to cut rates by 75 to 100 basis points by the end of the year, 10-year Treasury yields reacted accordingly, falling from 4 .30% at the end of July (they were 4.70% in April) to 3.65% in 2017. mid-September.

By mid-November, this trend had been entirely erased, with yields back above 4.40%, roughly where they were before markets priced in the Fed’s rate cuts This year. At approximately $1 trillion per year, interest on U.S. debt carries an effective interest rate (interest charges divided by debt balance) of 3%. However, as of mid-November, bond yields across the curve ranged between 4.25% and 4.75%, meaning interest charges are only increasing as older bonds cheap bonds mature and are refinanced with new, more expensive bonds.

Easy money, inflation and asset bubbles

At the end of 2020, the global stock of negative-yielding bonds reached an incredible $18.4 trillion. Let that sink in. $18.4 trillion in bonds where lenders – rather than earning interest – actually paid borrowers for the privilege of lending them money.

The direct cause of this unfathomable distortion was the fast and loose play of central banks, first and foremost the Federal Reserve, with their monetary policy. Forcing interest rates lower, creating money by the trillions, and fostering a reckless inflationary environment – ​​centered on capital markets and asset prices – produced unquestionably irrational market signals.

Faced with a much higher cost of living due to excessive government spending and money creation by the Fed, average Americans have resorted to gambling in these same capital markets. American households and nonprofits now hold nearly 42% of their financial assets in stocks, as stocks themselves reach all-time highs.

Faced with this raging asset bubble, the Fed is carrying out further rate cuts, the isolated effects of which are reflationist. And, all else equal, more inflation means higher yields on government bonds. It is increasingly unlikely that investors will accept a return that falls to zero after adjusting for inflation.

Reserve currency status

Sober and rational market observer Jim Grant recently compared the reserve currency status of the US dollar as follows:

(Reserve currency status) is like a well-off parent with a somewhat underachieving child saying (to that child), “Here’s $20 million, go out and drink yourself to death.” » This is, in a way, the privilege of the reserve currency.

Mr. Grant says it well. There is no doubt that the reserve currency status of the US dollar was abused, and this abuse was inevitable. Endless and costly wars, combined with rampant spending on political programs, drove the U.S. Treasury into bankruptcy. Honestly, no investor would lend to a private entity with such disregard for financial discipline and no sense of urgency to reverse course.

As with the pound before it, disorderly profligacy over a prolonged period is likely a harbinger of the dollar’s loss of status and there are already compelling signs that global markets are keen to decouple from the dollar, including a decline notable foreign holdings in US dollars. Treasury bonds relative to national assets, the latter category including Treasury bonds held by the Federal Reserve. This indicates that potential foreign buyers of U.S. sovereign debt are already wary of Uncle Sam’s rapidly declining credit quality.

There is no doubt that the specter of a loss of U.S. reserve currency status should cause Treasury yields to move by much more than a few dozen basis points, but bond markets often move at a glacial pace. Although slow, such movements are equally inevitable.

Something that can’t last forever

Equity is a bad thing, and the United States’ reserve currency status is likely to be seen in retrospect as a curse rather than a blessing. The Fed’s ability to print money stems in part from hubris of long-past geopolitical successes. These successes, combined with a level of economic dominance, have stimulated the appetite of foreign markets for all things dollar-denominated. Increasingly, this no longer seems to be the case, but the national trend to print and spend has not abated at all.

Those who continue to invest in U.S. government bonds—despite Congress’s deranged fiscal recklessness and the Fed’s improvised monetary policy—must do so with consideration of the borrower’s creditworthiness and the strength of its currency. . As Treasury yields rise, dependent markets including stocks and real estate will likely be affected as well. Investors of all stripes would therefore do well to remember how exchange rate regimes decline and asset bubbles burst – gradually, then all at once.

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