The US government’s finances keep looking worse. The latest Congressional Budget Office projections suggest that it will need to borrow an added $400 billion this year to cover its budget deficit — and trillions more over the next decade.
Investors have plenty of legitimate reasons to worry about this trend. The immediate effect on money markets isn’t one of them.
The CBO’s forecasts are truly dire. It has raised its estimate of the fiscal 2024 deficit to $1.9 billion from $1.5 billion, citing the costs of military assistance to Israel and Ukraine, student loan forgiveness and higher interest rates. It puts the ten-year deficit at $22.1 trillion, up from a February estimate of $20 trillion — and that’s based on the optimistic assumption that Congress won’t extend the provisions of the 2017 Tax Cuts and Jobs Act beyond 2025.
Larger deficits require greater borrowing. When the US Treasury unexpectedly needs to issued more debt, it usually does so by selling short-term Treasury bills, which it can roll over into longer-term debt if the higher borrowing persists. This has led to concerns that a flood of T-bills will hit the market, soaking up cash and triggering a spike in short-term interest rates like the one that rocked money markets in September 2019.
I doubt the added borrowing will be so disruptive, for three reasons. First, higher-yielding Treasury bills will attract much of the cash currently parked at the Federal Reserve’s reverse repo purchase facility, where investors (primarily money-market mutual funds) have lent about $380 billion against the collateral of Treasury securities, earning 5.30 percent. As usage of the facility contracts, that cash will end up at banks, increasing their reserves and reducing their short-term borrowing needs.
Second, the Fed is being very careful to ensure that banks have ample reserves to meet their liquidity needs, precisely to avoid a repeat of the 2019 turmoil. This month, for example, the central bank slowed the rate at which it is reducing its holdings of Treasury securities to $25 million a month, from $60 million. All else equal, more securities in the Fed’s portfolio means more cash reserves at banks.
Third, the Fed now has a standing repo facility, also a response to the 2019 turbulence. This guarantees that banks can always borrow cash against their holdings of Treasury securities, currently at 5.50 percent interest — effectively putting a ceiling on how high short-term interest rates can go, even if the demand for cash unexpectedly exceeds banks’ reserves.
So all’s good, nothing to see here? Of course not. The US is taking a big risk by running large and chronic fiscal deficits. The more it borrows, the greater the chance it’ll end up in a vicious cycle, in which government debt and interest rates drive one another inexorably upward. The rising debt burden also increases pressure on the Fed to devalue the debt by allowing inflation to rise — an outcome that a second Donald Trump presidency could precipitate.
It's impossible to know when investors will decide that such risks are too much to bear, as the bond vigilantes famously did in the 1990s. When it happens, it tends to be sudden and brutal. This is the concern that should be paramount.
Credit: Bloomberg
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