Obama’s Successor Inherits Bond Market at Epic Turning Pointby and
Tailwinds during his tenure now risk buffeting next president
Nation’s interest costs, already highest since 2011, to rise
Barack Obama will go down in history as having sold more Treasuries and at lower interest rates than any U.S. president. He’s also leaving a debt burden that threatens to hamstring his successor.
Obama’s administration benefited from some unprecedented advantages that helped it grapple with the longest recession since the 1930s. The Federal Reserve kept rates at historically low levels, partly by becoming the single biggest holder of Treasuries. The U.S. could also rely on insatiable demand from international investors, led by China deploying its hoard of reserves. Global buyers added $3 trillion of Treasuries, doubling ownership to a record.
Now those tailwinds are turning around. The Fed is telegraphing more hikes at a time when interest costs on the nation’s bonds are already the highest in five years. The government’s marketable debt has more than doubled under Obama’s stewardship, to a record of almost $14 trillion. And the deficit is expanding again, after narrowing for four straight years, just as overseas holdings of Treasuries are shrinking at the fastest pace since 2013.
“We’ve really got ourselves into a pickle here,” said Edward Yardeni, president of Yardeni Research Inc. in New York, who’s been following the bond market since the 1970s. “All these years we’ve been kicking the can down the road, and suddenly we’re seeing a brick wall.”
The deteriorating backdrop for the world’s biggest bond market risks spoiling the plans of Tuesday’s winner, whether it’s Hillary Clinton or Donald Trump. Both have promised measures to foster growth and create jobs. The prospect of the three-decade bull market in bonds approaching a turning point has implications for everything the candidates want to tackle, from infrastructure spending to national security to tax cuts.
In some ways, Obama lucked out. The Fed bought $1.7 trillion of Treasuries from 2009 to 2014, soaking up the equivalent of a quarter of the increase in debt outstanding. While its securities purchases helped support the bond market, the era of extraordinarily low rates also crimped returns for fixed-income investors. Treasuries have earned about 3 percent annually on average since 2009, the skimpiest since at least the Reagan administration, according to Bank of America Corp. data.
Benchmark 10-year yields have averaged about 2.5 percent during Obama’s terms, compared with about 4.4 percent under his predecessor, George W. Bush. Yields fell even as the economy recovered from the financial crisis and added jobs for six straight years. Stocks fared better than Treasuries: the S&P 500 Index generated a 15 percent annualized return under Obama, compared with an average of about 10 percent from 1980 through 2008.
America’s economic expansion hasn’t kept the debt burden from consuming an ever-greater share of the nation’s financial resources, promising to complicate the next president’s decisions. Though the deficit shrank as crisis-era spending ended, debt levels have still increased to pay for rising entitlement outlays. In fiscal 2016, the Treasury shelled out $433 billion in interest payments on the obligations, an amount that will swell as rates rise, as the Congressional Budget Office projects.
A measure known as net interest cost, which balances what the government receives in interest payments against what it pays on debt, will nearly triple by 2026, to $712 billion, the CBO forecasts. The expense would more than double as a share of the economy, to 2.6 percent.
Even without new fiscal spending, the U.S. is set to sink deeper into the red as revenue fails to match the growing expenses of Social Security, Medicare and interest costs, the CBO predicts.
“The Treasury has kind of gotten a free lunch over the last several years,” said Stephen Stanley, chief economist at Amherst Pierpont Securities LLC in New York, and a former researcher at the Richmond Fed. “Deficits had been artificially suppressed by the nature of monetary policy. Now you have structural issues with spending on entitlements, and a policy impetus that seems to be moving toward fiscal stimulus.”
While there’s no guarantee that either major candidate will be able to get their proposals through Congress, economists predict the potential shift toward looser fiscal policy will expand the debt burden.
Proposals from Democratic nominee Clinton include a $275 billion infrastructure plan that she intends to pay for through corporate tax-law changes. She’s also suggested tax increases for the wealthy. The plans would inflate the debt by $200 billion over a decade, according to analysis from the non-partisan Committee for a Responsible Federal Budget.
Trump, the Republican candidate, has made pledges including cutting taxes and spending as much as $500 billion on infrastructure. The proposals would boost the debt by $5.3 trillion, the Committee for a Responsible Federal Budget estimates.
With the debt load projected to soar, Obama’s successor can still count on domestic buyers, who have stepped up even as foreign central banks reduced their stake in Treasuries for an unprecedented three consecutive quarters. U.S. commercial banks, for example, boosted holdings of federal and agency borrowings to a record $2.43 trillion last month.
“One good thing for the new team that comes into the Treasury Department is that even as financing needs increase, the market clearly has the capacity for the additional supply,” said Amar Reganti, a fixed-income strategist in the asset-allocation group at GMO LLC in Boston and a former deputy director of the Treasury’s Office of Debt Management. “So, yields shouldn’t become unhinged.”
The next president can also depend on some of the monetary stimulus that prevailed during the Obama era to persist. The Fed isn’t about to shrink its $4.45 trillion balance sheet anytime soon. And while policy makers’ median projection is for two rate increases in 2017 after a hike next month, swaps traders see just about one move in that span, for the shallowest tightening cycle ever.
That all may change, though, if inflation accelerates.
Fed officials said this month that the pace of price gains has increased, and a steepening in the Treasury yield curve since August suggests bond traders agree inflation is picking up. If the economy starts running hot even before new fiscal spending, the combination may spur inflation to rise more quickly, undermining the value of bonds’ fixed payments.
An Atlanta Fed index estimated on Friday that the economy is expanding at a 3.1 percent annual rate this quarter, signaling the U.S. may be on track for its strongest back-to-back quarters since 2014.
The scenario of quicker growth and inflation may push Wall Street to ramp up expectations for Fed hikes and anticipate higher yields for years to come.
The consensus is for benchmark 10-year Treasury yields to rise to 2.13 percent at the end of 2017, from about 1.8 percent as of 8:15 a.m. in New York, according to the median forecast of economists surveyed by Bloomberg.
“There’s been so much borrowing going on that’s been enabled by extremely low interest rates, one shudders to think what would happen if rates actually ever did go back to normal,” Yardeni said. “The impact on the interest expense would be significant, and could really bring deficit concerns back to the fore.”