No, the Bond Market Isn’t About to Implode. The Case for Boring.

About the author: Larry Hatheway is a co-founder of Jackson Hole Economics, which originally published this commentary, and the former chief economist of UBS.

A quick perusal of social media reveals lots of posts warning of an impending U.S. bond-market implosion. Exponential growth rates of government deficits and debt, central banks shrinking their bond holdings—that’s the stuff of a never-ending internet horror show.

But is a U.S. debt crisis likely?

Clearly, some stoke fear for personal gain, such as those who pimp cryptocurrencies. That aside, might there be legitimate reason to fear U.S. public debt dynamics?

In what follows, I explore the issue, with a focus on the U.S. Treasury bond market.

It’s all relative

To begin, it’s advisable to look at debt relative to income. Dollar values are inflated and misleading. What really matters is borrowing relative to debt servicing capacity.

Today, U.S. gross federal government debt amounts to about 121% of U.S. gross domestic product. That’s below its pandemic and postwar peak of 126%, but more than twice its 55% level at the turn of this century.

Contrary to popular belief, the stock of U.S. federal government debt relative to GDP does not always go up. In 1946, in the immediate aftermath of World War II, U.S. federal government debt peaked at 119% of GDP (that is, roughly where it is today), and then proceeded to decline steadily and almost without interruption to a low of 31% in 1981. It then climbed to nearly 65% of GDP in 1995, before declining in the ensuing half-decade by roughly 10 percentage points.

U.S. fiscal history is important for several reasons. First, despair isn’t warranted. Levels of government indebtedness relative to income can and do fall. Second, periods of falling debt relative to income occur in part because of fiscal discipline, but mostly because of strong growth. Third, falling debt-to-GDP ratios do not require high inflation. The postwar decline in the U.S. debt-to-GDP ratio was not accompanied by persistently high inflation. Finally, much of the increase this century is due to the global financial crisis and the pandemic. Strip those away, and U.S. federal government debt today would be around 70% of GDP.

Perhaps voters are to blame?

It is nevertheless easy to point to capricious politicians in Washington as the reason U.S. deficits and debt are so big. But is that right? In the 2000 and 2016 presidential elections, voters rewarded Republican challengers advocating tax cuts, rather than Democratic candidates offering continuity of fiscal discipline. Also, in the late 1990s and again during the early 2010s, voters rejected Republican congressional deficit “hawks,” such as former House Speakers Newt Gingrich, John Boehner, and others.

If Democrats and Republicans today are reticent to push legislation to raise taxes or cut spending, perhaps that is because voters have not rewarded the politics of fiscal discipline over the past quarter-century.

Are bond investors complacent?

But if U.S. voters are to blame for lax fiscal policy, why are bond investors blasé? That question becomes more interesting as the Federal Reserve sheds its bond holdings under quantitative tightening. Why hasn’t the combination of fiscal indifference and a shrinking Fed balance sheet sent the bond market reeling?

To see why the bond market is sanguine, we need to review some national-income accounting.

It is an accounting truism that the budget deficit must be financed by some combination of borrowing from abroad and by excess private sector savings beyond what is required to finance business investment.

In recent years, the foreign sector has played a big role in financing U.S. government borrowing. For example, when the U.S. budget deficit mushroomed during the pandemic, so did the U.S. current account deficit. (It widened from around -1.9% to -4.5% of GDP from 2019 to 2022.)

Foreigners have been enticed by higher U.S. yields, but not dramatically higher ones. That’s because the big-three—Europe, Japan, and China—are all experiencing economic stagnation or worse. They have excess savings looking for a home, and that home has become the U.S. Treasury market, manifested in a surging U.S. dollar in the foreign exchange markets.

Meanwhile, U.S. households have been saving more since the global financial crisis, meaning that domestic savings have also financed government borrowing. U.S. households have also reduced their borrowing. According to the OECD, U.S. household debt as a share of GDP has fallen by nearly a third since 2007. Corporate borrowing, as a share of GDP, has remained relatively constant for more than a decade.

Accordingly, since 2010 U.S. federal government borrowing has been financed out of higher household savings, accompanied by subdued private sector borrowing are larger foreign lending.

What about the Fed?

But wait, isn’t the Federal Reserve the “straw that stirs the bond market”? Isn’t the Fed the reason why bond yields have been so low over the past 15 years? Won’t its departure as “buyer of last resort” inexorably raise bond yields?

Unquestionably, bond yields reflect, in part, the expected future path of short-term interest rates, which the Fed controls. They are also influenced by the central bank’s large-scale asset purchases. “Forward guidance,” namely the projection of future Fed policy intentions, also matters.

But the Fed might not be as influential as is widely believed. As the Fed has tightened in recent years, U.S. and foreign savers have responded to rising interest rates, while private sector borrowing has been restrained. Higher yields have “crowded in” savings and “crowded out” borrowing, creating sufficient scope to finance even enormous U.S. government deficits without requiring a huge jump in bond yields. In short, (global) savings and investment have responded elastically to rising interest rates.

Can bonds remain boring?

But the question remains: Can bonds remain boring, or will the debt Cassandras be right?

The answer: It depends.

Here are some factors that would push interest rates higher. First, growth in Europe, Japan, China would have to accelerate, reducing global savings and increasing global investment. Alternatively, U.S. business investment would have to boom, accompanied by a decline in household savings. Or U.S. inflation would have to re-accelerate. Finally, investors might attach a default premium to U.S. Treasuries.

Any of the preceding five outcomes is possible, but are any of them probable?

Many seem unlikely. Foreign growth is anemic for well-known reasons due to demographics, geopolitics, or a gross misallocation of resources, depending on where one looks. A U.S. investment boom is possible, but it hasn’t occurred despite more than a decade of soaring profitability, dazzling innovation, and superlow borrowing costs. So, why should it change now? U.S. households may begin to save less, though why that should be the case is not obvious. Inflation could rise, though it seems more likely to fall.

Which leaves the final concern: a U.S. default premium. That seems unlikely to emerge simply because of the size of U.S. debt, but if U.S. voters reward politicians of both parties and ignore the need to address fiscal overreach, then one day the bond market may respond.

For now, however, the odds are stacked in favor of bonds remaining boring. That’s not what you’ll find on social media. But, then again, when was the last time you found anything useful on social media?

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