Morning Commentary: The Fed and Sustainability of Government Debt

A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.

The Fed and Sustainability of Government Debt Share this story: Andrew Kositkun Foreign Exchange Head Trader

Since the start of the COVID-19 crisis, there has been a large surge in U.S. federal debt and the Fed’s holding of Treasuries. However, despite this increase, the percent of outstanding marketable Treasury securities held by the Fed is less than 2% higher than the previous peak level at the end of QE3. Given the large role that the Fed plays in buying federal debt, a key concern is what happens to yields when the Fed withdraws its support. When answering this question, it is important to understand that the Fed is highly unlikely to withdraw support until the economy is well on its way toward a full recovery. Additionally, it is important to understand why bond yields are low to begin with. Certainly Fed bond buying helps, but there are also other key factors. These factors include the following: Equilibrium real interest rates, or the real rates of return required to keep the economy’s output equal to potential output, have been dropping for a while now. According to a widely cited measure, the equilibrium real interest rate dropped from 2.4% in 2007 to 0.3% in the second quarter of 2020. Inflation expectations have taken a similar drop. As a result, the inflation compensation embedded in bond yields has also fallen. During the last business cycle when many economies were at or above full employment, central banks around the world were unable to hit their inflation targets. The COVID-19 shock has only made the inflation issue worse. Overall, the drop in inflation expectations, and thus inflation compensation in bond yields, seems semipermanent. There aren’t really any good alternatives to U.S. Treasuries. Many governments outside the U.S. have negative or near-negative yields. Further, the U.S. has an inherent advantage, as it is at the center of global capital markets and has the deepest bond market as well as the pre-eminent reserve currency. These factors all point to continued demand for Treasuries beyond the Fed. There is also historical precedent. Japan has been running huge deficits for much longer, and its debt-to-GDP ratio is much higher than the U.S.’s ratio. Despite this, Japanese bond yields have remained super low even during periods without Bank of Japan bond buying. When the Fed surprised markets back in 2009, bond yields moved significantly, so it is understandable why markets assign weight to the Fed’s bond-buying policies. However, subsequent rounds of quantitative easing (and so-called quantitative tightening for that matter) have had smaller effects. Ultimately, the factors discussed above combined with an extremely cautious Fed argues against a major bond market shock once the Fed decides to withdraw support. HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: More than 82 million ballots or ~60% of 2016’s total, have been cast, with Hawaii and Texas already exceeding its 2016 total. The string of negative virus news continues to hit market sentiment. Global infections now total more than 45 million cases, with daily U.S. infections topping 89,000, which is a new record high. U.S. personal income and spending both topped expectations, with personal income increasing by 0.9% versus expectations for a 0.4% increase and personal spending increasing 1.4% versus expectations for a 1% increase. Euro-area GDP surged by 12.7% in the third quarter against expectations for a 9.6% rise. France, Italy and Spain all had double-digit increases with, Germany’s GDP increasing 8.2%. However, these numbers are backward looking, with more up-to-date indicators suggesting a bleaker picture as rising COVID-19 numbers and increased lockdown restrictions put the euro-area economy at risk of double dipping. The outline for China’s upcoming five-year plan has started to emerge. No numerical growth targets were given, as Chinese officials chose to focus on qualitative goals rather than quantitative ones. The plan calls for self-reliance in technology and a boost in domestic consumption that relies more on domestic resources. These changes are not surprising and reflect the new normal regarding China’s trading relationship with the West.

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