Monetary Policy & Inflation | US
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Summary
- A US Treasury crisis is unlikely but not impossible. Here, I run a pre-mortem (i.e., assume a crisis has happened and work backward to identify likely causes).
- Two decades of loose fiscal policies and structural changes to the demand for Treasuries have placed the US in the danger zone, though that is not enough alone to lead to a full-fledged crisis.
- A short-term trigger is needed, and these could include recession, trade war escalation, debt ceiling brinkmanship, or an attempt to fire Chair Powell, none of which seems likely.
Market Implications
- I still expect two-three 2025 Fed cuts, against markets pricing two.
Crisis Are Rarely Consensus Forecast
Crises are almost never consensus forecasts. If they were, market participants would pre-empt them, and they would not happen.
Most crises involve the falsification of a strong consensus view. For instance, belief that US real estate prices could not fall before the GFC.
This time, the strong belief could be that the US Treasury market will never lose its safe haven status. Recent price action has tested it, which saw a large, combined bond and dollar selloff (Chart 1). Could it turn into a full-fledged US sovereign debt crisis? This seems unlikely but not impossible. Here, I use a pre-mortem technique to highlight the risks.
Post-mortems are ex-post analysis of projects, typically because they failed. By contrast, pre-mortem analysis assumes a project has failed and works backwards to identify the possible causes. This technique is especially helpful when consensus is strong.
I start by describing what a US sovereign crisis could look like.
Crisis Would Involve Unprecedented Bond and USD Selloff
A US sovereign crisis would involve a combined Treasuries and dollar selloff well more than April’s volatility. For instance, a 1ppt increase in the 10Y term premium and a 5% MoM decline in the DXY index. There could be contagion to global bond markets and US banks could come under pressure.
By comparison, British Prime Minister Truss’ brush with markets would seem of limited magnitude. After Truss was voted into office on 5 September 2022, she introduced measures that would have added about 6ppt of GDP to the deficit over five years. Gilts and the GBP sold off sharply and Truss eventually resigned on 20 October (Chart 2). There were no lasting market consequences.
A crisis requires long-term destabilising trends and a short-term trigger.
Two Decades of Loose Fiscal Policies
US fiscal consolidation effectively ended in 2001. Primary deficits have been on an increasing trend since then (Charts 3 and 4).
Favourable debt dynamics – nominal GDP growth well above the average interest rate paid – kept the debt-to-GDP ratio roughly constant between 2002-08. However, fiscal loosening was already well underway as the increasing primary deficit (deficit excluding interest payments) showed.
After the GFC hit in 2008, marketable debt increased by $6.7tn or 36ppt of GDP to 69% of GDP in 2013 (Chart 5). But debt kept increasing faster than GDP even in the recovery.
In 2020, the US was hit by the pandemic and debt jumped by another 22ppt of GDP to 99% in 2021. Due to unanticipated inflation, the debt to GDP ratio fell during 2021-22 but recovered thereafter. There was no fiscal consolidation in the aftermath of the pandemic other than through automatic stabilisers (higher revenues and lower spending associated with the recovery).
The budget bill under discussion in Congress would raise debt to 125% of GDP by 2034 from currently 97%. However, even based on current budget law (i.e., without extending the Trump 1.0 tax cuts) debt was expected to rise to 117% of GDP by 2034.
As a result of more than two decades of rising debt, interest payments now represent 14% of expenditures and 3% of GDP (Chart 6). The Congressional Budget Office baseline projections see a stable interest expenditure share, but this is based on the 10Y yield remaining below 4% throughout the next decade.
Against rising sovereign leverage, the demand for Treasuries has become more price sensitive.
Treasury Demand Becoming More Price Sensitive
Official demand for Treasuries from the Fed, global central banks and foreign official agencies, which is least return sensitive, is falling (Chart 7). Fed demand is unlikely to increase unless the FFR hits the zero bound, which I believe is unlikely despite recession risks. Foreign official demand is unlikely to increase either. The flip side of the Trump administration’s demand that countries lower their trade surplus is no more FX reserve increases and therefore demand for US Treasuries (Chart 8). Also, the share of the USD in global FX reserves is falling (Chart 9).
By contrast, foreign private investors are likely to have global mandates and therefore compare Treasuries with government bonds in multiple jurisdictions. This makes them the most price sensitive category of investors. Foreign private investors are now the largest non-official holders of Treasuries.
US-based financial and non-financial investors tend to be less price sensitive than foreign private investors due to home country bias or investment mandates that limit them to Treasuries.
The administration plans to relax prudential regulation, including the SLR, which could see an increase in Treasury demand from banks. However, banks’ holdings of Treasuries are near historical highs. Also, bank deposits growth has been sluggish due to a still substantial gap between deposits and money market fund rates (Chart 10). And while MMF demand for Treasuries is likely to grow in line with their assets, they are focused on T-bills rather than coupons.
Two decades of loose fiscal policies and changes in the demand structure have placed the US in the danger zone. Yet it does not mean a crisis is imminent. Rather, a crisis is likely to require a trigger.
Trigger Needed for Full-Blown Crisis
Most crises reflect a combination of long-term unfavourable trends and of a short-term trigger. In the case of the GFC, the long-term build-up of household and bank leverage may not have resulted in a full-blown crisis without the Lehman Brothers bankruptcy, which was a catalyst for these underlying long-term weaknesses.
Two potential catalysts exist for the current the Treasury market: loss of confidence and adverse flows. Relative to its fundamentals alone, the US is likely overrated (Chart 11). For instance, US government total debt is well above that of similarly rated Austria and Finland. Portugal is rated A3 against the US Aa1 while having sovereign leverage comparable to the US and support from the ECB.
In this context, a loss of confidence in the Treasury market safe haven status could become a self-fulfilling prophecy. Possible triggers include:
- President Trump attempting to fire Chair Powell. This could fuel concerns of loose monetary policy and risks that Treasuries could be repaid with a devalued currency. These concerns are likely to be top of mind with investors because the dollar is near a historical high (Chart 12).
- Debt ceiling brinkmanship. Treasury Secretary Bessent has warned the Treasury could run out of cash as early as August if the debt ceiling is not raised. While the Republicans control the House and Senate, internal dissensions between fiscal conservatives and centrist could delay an increase in the debt ceiling. Past episodes of brinkmanship have always been resolved without crisis, but miscalculations are possible.
- Poor bond auctions. A long enough series of these could undermine confidence.
Alternatively, a crisis could be triggered by actual Treasury flows (i.e., adverse changes to the supply/demand balance). For instance, a recession would likely see the deficit increase from already very high levels even without fiscal stimulus (Chart 13). A trade war escalation could see large holders of Treasuries liquidate them. For instance, China could liquidate its holdings if it faced pressures on its currency (Chart 14). In Japan, a prominent politician recently suggested Treasury holdings be included in ongoing negotiations with the US.
Market Consequences
In my three scenarios – recession, self-correcting weakness, and Treasury crisis – I attach a 20% probability to a Treasury crisis. This reflects poor US debt fundamentals, which will not become a full-fledged crisis without a catalyst that more likely than not will not materialise.
This analysis does not change my Fed view that remains two-three cuts in 2025. I believe recent comments from FOMC members that the Fed may not cut until September ignore signs of demand weakness and subdued inflation so far. My view compares with markets pricing two 2025 cuts.
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