A deficit reduction bill should push interest rates higher

Markets got excited yesterday at the prospect that Congress may be closing in on a bipartisan deficit reduction bill. 30-yr Treasury yields fell 12 bps, as investors reasoned that a reduction in federal debt issuance would lead to higher prices for Treasury debt. (Much of that drop in yields has been reversed so far today.)

I think this is one of those times when the bond market's initial reaction to some new and important development is wrong, or at least not well thought out.

To understand why, it is important to realize that yields on Treasury notes and bonds are fundamentally determined by inflation and inflation expectations. Inflation expectations, in turn, can be impacted by the market's perception of the economy's strength, because the market, and the Fed, believe that strong growth can add to inflation pressures, while weak growth creates deflationary pressures.

It's also important to understand that every bond issued in dollars is priced relative to Treasuries of a comparable maturity. Since Treasuries are the risk-free bedrock of the dollar-based bond market, non-Treasury securities have to pay a higher yield, or spread. That spread can change, of course, but if Treasury yields rise significantly, then it's a safe bet that the yields on all bonds will rise significantly.

The larger point here is that a change in the yield on Treasuries affects the yields on all bonds. Treasuries do not exist in isolation.

Our current $1.3 trillion federal deficit is a fairly large percentage of the $9.7 trillion of Treasury debt held by the public (about 13.5%), but the marginal borrower (in this case the U.S. government) does not set the price of the outstanding stock of U.S. debt, which is more than $30 trillion. Even very large $2 trillion deficits would have little impact on the level of bond yields, because the new supply of bonds would still be only a small fraction (6-7%) of all the investment-grade and high-yield bonds outstanding in the U.S. market. And I'm not even considering the more than $30 trillion in liquid, non-U.S. bonds outstanding in the world. Let me hasten to add that new Treasury issuance need not have any direct impact on inflation fundamentals, unless the Fed takes action to expand the money supply by more than the world desires.

Whether the federal government borrows $2 trillion or $1 trillion in the next year is not going to have much of an impact on the level of interest rates, taken in isolation, because the outstanding stock of bonds is orders of magnitude bigger. What could have a meaningful impact on interest rates, however, is how meaningful the package of spending cuts turns out to be. Many worry that a big cut in spending would weaken the economy, and that in turn would lead to lower inflation and lower interest rates.

But I think that a big cut in future spending would have a positive impact on the economy, since it would free up resources that can be better utilized by the private sector, and, by reducing future deficits, it would greatly increase the expected after-tax returns to investment. Combined, this could prove to be a powerful stimulus to growth. And so I think that upon reflection, a serious debt reduction package would eventually be perceived by the market to be good for the economy and therefore "bad" for the bond market, and that would mean higher, not lower yields.