Portfolio Manager
A traditional fair value model for US Treasury yields has been successful at explaining the level of interest rates over time using a few simple variables such as market expectations for Federal Reserve (Fed) policy, economist expectations for growth and inflation over the short and medium term, the relative size of the Fed’s balance sheet, and some measure of current activity or sentiment, like the Institute for Supply (ISM) manufacturing survey. At the time of writing, our own internal model of similar construct suggests a fair value for the ten-year US Treasury yield around 4.35%, with a one standard deviation residual between the actual tradeable yield and the fair value being around 20 basis points (bps).
While this is all well and good, Moody’s recent downgrade of US Treasuries from AAA to Aa1 – bringing the rating in line with Fitch and S&P – as well as the ongoing budget reconciliation process in Congress, highlights an important question: how does the US budget deficit factor into this fair value analysis?
Moody’s rationale for the downgrade was as follows1: “As deficits and debt have grown, and interest rates have risen, interest payments on government debt have increased markedly…We expect federal deficits to widen, reaching nearly 9% of Gross Domestic Product (GDP) by 2035, up from 6.4% in 2024, driven mainly by increased interest payments on debt, rising entitlement spending, and relatively low revenue generation.”
At the same time, Moody’s affirmed a stable outlook ahead: “The US economy is unique among the sovereigns we rate. It combines very large scale, high average incomes, strong growth potential and a track-record of innovation that supports productivity and GDP growth…In addition, the US dollar's status as the world's dominant reserve currency provides significant credit support to the sovereign. Despite reserve diversification by central banks globally over the past twenty years, we expect the US dollar to remain the dominant global reserve currency for the foreseeable future.”
While appreciating the special factors of the US as a sovereign (reserve currency, depth of liquidity, etc.) and the fact that the deficit trajectory is clearly unsustainable over the medium term, the way the budget deficit fits into our fundamental fair value framework discussed above is through expectations of higher growth and higher inflation as well as its impact on the Fed’s expected policy path. To evaluate this, one must use a combination of art and science to translate the expected deficit expansion into a “fiscal impulse” estimate. Evaluating a moving target is inherently challenging, especially as Congress is actively in the process of negotiating a deal that is likely to evolve. Nevertheless, using what we have from the bill passed by the House, our Investment Bank estimates a fiscal thrust of around 0.4% of GDP next year2. The major offsetting factor not considered in that estimate is the revenue raised by tariffs (which can be considered a tax increase) and the subsequent hit to growth associated with it which could counterweight the fiscal impulse. Some economist estimates suggest that the fiscal thrust could be smaller or even negative when combined with the tariff impact given the composition of the additional deficit expansion. For example, changes in corporate deductions could have a smaller immediate impact on growth relative to the same dollar amount allocated towards an explicit increase in healthcare spending or decrease in individual taxes. In addition, the CBO estimates that the fiscal multiplier of the House’s proposed bill could be lower due to the larger benefit accruing to higher-income households with a lower marginal propensity to consume3.
If the impact to growth and inflation of the proposed budget plus tariff policy is more limited and efficiently priced into current markets, measuring the additional valuation impact of more Treasury supply – as a function of running structurally higher deficits (above and beyond the impact to growth and inflation) – becomes more difficult but is often described as an amorphous “term premium”. When deficits grow in good times (i.e. non-recessionary periods), one could argue there is a need to be paid more for the risk premium of buying longer-dated Treasuries. This is more difficult to prove using prior periods in time. We have had periods of high term premium in expansions while the US was running a budget surplus (1998 – 2001) as well as periods of low or negative term premium during expansions despite the US running a budget deficit (2017-2019), as shown in Exhibit 1. Admittedly, there are differences between both time periods and today. Perhaps the record level of outstanding debt to GDP and historically elevated policy uncertainty makes this time different. Despite much brainpower applied to the topic, no definitive debt-to-GDP ratio has been identified that automatically results in a funding crisis. Calculating the additional yield demanded to compensate for debt sustainability risks can be highly stylized based on an investor’s view on future spending, growth, and interest rates. This leaves high policy uncertainty (trade, budget, geopolitical and more) as a more likely culprit to explain expanding term premium.
Even in the absence of legitimate debt sustainability concerns or elevated policy uncertainty, question marks remain around the balance between demand and supply for US Treasuries, including the appetite of foreign investors, especially for long end maturities. This balance has been shifting for several years now and in many ways is not a new phenomenon. While outright holdings of US Treasuries by foreigners have continued to grow through March, the share of holdings by foreigners as a percent of total supply has been declining for the last ~15 years (Exhibit 2). In addition, central banks have moved from quantitative easing (QE) to quantitative tightening (QT). These question marks around the demand supply balance are not limited to the US. In Japan and the UK, long end yields are also reaching multi-decade and, in some cases, all-time record highs. Debt management offices, like the Treasury in the US, do have some tools to address this imbalance by adjusting the weighted average maturity of issuance, but it is not a silver bullet. The private sector is the price setter now and is more price sensitive. In the end, this shift actually makes bonds a more attractive asset, but the journey to the new equilibrium is painful.
The story for long end demand is not exclusively negative. The Fed is in the process of winding down QT and we believe there is plenty of private demand for high quality US fixed income from both domestic and foreign asset managers serving both institutional and retail clients. For this large pool of capital, the biggest roadblock has been the correlations between bond and equity prices and the residual scarring from bond market underperformance over the last few years (especially 2022). Cooling inflation, which continued through April according to recent Consumer Price Index (CPI) and Producer Price Index (PPI) reports, should help restore the correlation over time but concerns persist that tariffs will disrupt that progress. Relative to a few years ago however, Fed policy remains restrictive, and the Federal Open Market Committee (FOMC) is biased towards rate cuts if tariff-related inflation proves temporary. Over time, high Treasury yield levels should lure in investors with the prospects of building more resilient portfolios with higher income so long as the Fed maintains a credible easing bias through anchored long-term inflation expectations. To the extent elevated long-end yields reflect excessive optimism around a lower effective tariff rate and more fiscal stimulus ahead, risks to the market and Treasury yields appear more two-way going forward.