One cost of the debt ceiling crisis that is lost among most political actors and the public is that the U.S. Treasury will need to refill its coffers.
That need to sell debt—$1.1 trillion of it—along with a strong probability of another Federal Reserve rate hike or two during the third quarter, will push interest rates higher, raising the cost of doing business.
The Treasury on Wednesday said that it would issue enough notes to lift its cash balance to $425 billion by the end of June.
We think that the Treasury issuance over the next six months will be sufficient to push the 10-year yield toward 4%.
The burden of these higher rates will fall on small and medium-size firms as the issuance pushes up the cost of credit by an equivalent of a 25 basis-point rate hike by the Federal Reserve.
If there is a silver lining, it is that the risks of default in the money markets, and the costs of hedging that risk, are now resolved.
Two canary-in-the-coal-mine measures of financial market risk quickly reverted to reasonable levels as the debt-ceiling talks reached a resolution. And a third measure of distress in the Treasury-bill market appears to be resolved.
FRA/OIS spread: First, the spread between forward rate agreements and the overnight indexed swap rate measures expectations of risk in the money market. FRA is the exchange of a fixed interest rate for a floating rate, or the interest rates demanded by banks. OIS is a proxy for the federal funds rate, or the risk-free interest rate.
The FRA-OIS spread remains elevated, which is most likely because of concerns over the impact of the significant issuance of debt as the Treasury gets back to normal business. Nevertheless, and perhaps more important, it has dropped well below the crisis levels of the past 15 years.
Credit default swaps: The second sign of reduced risk is the behavior of credit default swaps, in which investors can pass the risk of a holding a security on to someone else.
The CDS is an insurance policy. The cost of that insurance rocketed to panic levels during the debt ceiling standoff and returned to normal as a deal was reached.
Treasury bills: Third and finally, Treasury bill rates have been re-established at normal levels relative to their maturity.
One-month T-bills that had been trading at higher rates of interest as the risk of default drew nearer are now trading at 4.9%, 37 basis points lower than three-month bills trading at 5.3% and 50 basis points lower than six-month bills trading at 5.4%.
Expectations of Fed policy
Because of indirect tightening during the crisis, the forward markets are anticipating a Fed rate hike but not until the July meeting. That would be followed by a pause and then a gradual unwinding of the federal funds rate to 3%.
A shift in longer-term yields …
With the exception of periods of duress or extreme policy changes, Fed policy is usually not the sole determinant of long-term interest rates.
…have come with a shift in expectations for the Fed…
Rather, the yields on long-term Treasury bonds are subject to perceptions of both the expected path of monetary policy and the risk of deviations from that path over time. Those deviations are a product of economic growth and its effect on price stability, whether inflation, disinflation or deflation.
…and expectations for lower inflation.
In this most recent period, 10-year yields have increasingly become attuned to the Fed’s response to geopolitical shocks and their effect on expectations of price stability.
Investors are waiting for a return to normal…
After an unanchored period caused by the threat of default, we could expect a return to normal progression of Treasury auctions as confidence returns.
…which includes reduced volatility…
As the inflation shock subsides and as issuance returns to normal, we can expect bond yields to be determined more by the health of the economy and its ability to support normal levels of interest rates. That would imply a drop from the elevated level of Treasury market volatility.
…and lower inflation expectations.
For now, the headline inflation rate of 4.9% continues to inflict damage on households, particularly with respect to rent and food costs, a grave concern for the Federal Reserve. Inflation expectations for the next few years remain far enough above the Fed’s official 2% target for the central bank to maintain its hawkish stance.
The takeaway
With expectations that the high cost of capital and credit at the front end of the yield curve will bring about a slowdown, we expect longer-term interest rates to continue to be lower than rates at the front of the curve. The abnormal shape of an inverted yield curve has in the past been a precursor to slowing growth and, eventually, a recession.
For as long as inflation persists, we can expect real (inflation-adjusted) interest rates from two years’ maturity to 30 years to remain negative, which has added to the hot housing market and ultimately supports further rate hikes by the Fed.
