Bond Yields on the Rise: A Necessary Correction Amid Fiscal Woes

In recent months, and especially over the last 30 days, the bond market gave way to a noticeable increase in yields (with a correlated drop in bond prices), a development that some analysts outside of the financial media regard as a welcome correction. The upswing, mirroring a broader economic milieu, bears implications for both investors and the nation's fiscal health.

The bond market's yield revival (the 10-year is at 16 year highs) can - and probably should - be seen as a positive turn following a decade and a half of loose buying by the nation’s central bank. The correction can be attributed to several factors, primary among them being the pause in the Fed's easy money policy. Risk is again being priced into the market now that the bond market’s backstop has been removed. Currently the Fed is unloading Treasurys and mortgage-backed securities at a clip of about $95 billion a month (through natural maturation). Combined with a stronger-than-average risk of another rate hike and a future recession, investors see risk in existing 10-year bonds, noting that new issues and alternatives may provide a greater return.

With the nation’s most prominent purchaser taking a break, the basic economic principals of yore are bringing back market discipline, forcing investors to choose projects more carefully, as well. Get it right or risk not being able to cover the cost of your capital. When markets work efficiently, capital flows to the most productive investments. Distortions aside, supply and demand is sending the shock to the bond market that has been long overdue; in the long-run, more efficient use of capital can only improve our economic outlook.  

However, this bond market correction unfolds against a backdrop of a grim fiscal reality. The soaring interest rates spell trouble for the nation's long-term debt sustainability. The yield on 10-year Treasury notes amplifies a growing fiscal burden as the cost of refinancing the country’s existing debt surges. This scenario is exacerbated by the fact that the interest rates on new debt now significantly exceed the expected growth rate, potentially propelling the national debt to unmanageable proportions in the absence of corrective fiscal measures. (Google “r<g” for more on this.)

The Congressional Budget Office's earlier projections have been outstripped by the current interest rates, which, if sustained, could inflate the national debt by an additional $2.8 trillion through 2033 (that’s on top of current projections). The spiraling interest costs, if unchecked, could eclipse significant portions of federal spending, necessitating urgent fiscal reforms to stave off a potential debt crisis. In the recently closed fiscal year, spending on interest alone ($807B) was higher than spending on our entire defense budget ($695BN).

The bond market correction may herald a favorable tide for some investors and the overall long-term economy, yet it casts a long shadow on the nation's fiscal landscape. The interplay between the bond market dynamics and the fiscal scenario underscores the exigency of balanced economic stewardship to optimize our economic potential while averting a looming fiscal calamity.