Investor Demand for US Bonds Weakens, Signaling Fear for America’s Fiscal Health

Trays of printed Social Security checks wait to be mailed from the U.S. Treasury's Financial Management services facility in Philadelphia on Feb. 11, 2005. (Bradley C. Bower/AP Photo)

Financial markets could be signaling that demand for U.S. government bonds is starting to weaken following abysmal results at a recent Treasury auction.

The United States sold $20 billion of 30-year bonds at an Oct. 12 Treasury auction. Primary dealers—financial institutions required to participate in these auctions and purchase supply not acquired by other bidders—scooped up more than 18 percent of the bonds, higher than this year’s average of nearly 11 percent.

Investors sat on the sidelines during the proceedings, leading to a higher-than-expected yield for the long-term Treasury security. The highest yield accepted for the 30-year bonds was 4.837 percent, about 4 basis points higher than the projected yield before the auction.

Some market observers purport that the tepid demand for the 30-year bonds might not accurately depict what investors are thinking. However, recent auctions also recorded weaker demand for three-year and 10-year Treasurys.

During an Oct. 10 auction, dealers bought 22 percent of the supply of $46 billion of three-year bonds. At an Oct. 11 event, dealers picked up 19 percent of the supply of $35 billion of 10-year Treasury securities.

Industry experts warn that this is another clear sign that the volatility in the bond market isn’t over and that the rout could persist. During the latest selloff, the two-year, 10-year, and 30-year yields climbed to their highest levels in 16 years as investors fear that the Federal Reserve isn’t finished raising interest rates amid the reacceleration of inflation and better-than-expected labor market data.

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According to the Summary of Economic Projections, the Fed is penciling in one more hike to lift the median policy rate to 5.6 percent. The central bank has kept the target Fed funds rate at a range of 5.25 to 5.5 percent. Monetary policymakers trimmed their expectations for rate cuts by 50 basis points for later next year.

In other words, Fed officials expect higher-for-longer rates. At the same time, several regional Fed bank presidents have noted that the latest acceleration in Treasury yields could help the institution in its tightening crusade, meaning that the Federal Open Market Committee wouldn’t need to raise rates additionally.

State of Treasury Securities

Over the past year, there has been a debate about whether sufficient liquidity exists in the bond market amid the Federal Reserve’s quantitative tightening campaign since March 2022.

In October 2022, Treasury Secretary Janet Yellen conceded that she was “worried about a loss of adequate liquidity in the market” amid growing costs. But she was still confident that the market was functioning well and that her department would assess the steps necessary to improve the Treasury market.

One of the main challenges is that the U.S. government has been oversupplying markets with bonds.

After draining the Treasury General Account during the government default saga in the first half of this year, the department has been flooding capital markets with Treasurys. In the third quarter, it was estimated that more than $1 trillion in bonds were issued. Officials plan to sell another $850 billion in Treasury securities in the fourth quarter.

In addition to replenishing its bank account at the Federal Reserve, Washington has been looking to raise more cash to fund its ballooning national debt and budget deficit as tax revenues have slumped and spending has grown. However, should the lack of investor demand persist heading into 2024, it could support the case that the financial markets are becoming fearful of the federal government’s deteriorating fiscal condition.

In August, Fitch Ratings downgraded the U.S. credit rating to AA+ because of “the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance.” The agency noted that the federal government faces a plethora of fiscal difficulties, including the exceptional increase in the interest service burden.

The national debt recently topped $33.5 trillion, while the federal deficit is close to $2 trillion in the current fiscal year. Interest payments will be approximately $1 trillion this year.

Another demand factor is that the United States may need to compete for investors as central banks raise rates in response to above-trend inflation. If other markets are witnessing rising yields, the United States might need to offer better returns for investors.

In the UK, the 10-year bond recently touched a 15-year high of about 4.5 percent.

The Bank of Japan recently rattled international financial markets when it confirmed that it would allow the yield on its 10-year bond to rise a bit more.

Some assert that the Fed could eventually intervene and buy government bonds. But this would reverse the efforts made by the central bank to trim its balance sheet, which is still well above the pre-COVID-19-pandemic level of about $7.9 trillion.

For the week that ended on Oct. 12, the Fed maintained close to $5 trillion in Treasury securities, according to the H.4.1 data.

Good News and Bad News

The good news is that a chorus of experts, including Goldman Sachs Research’s Chief Interest Rates Strategist Praveen Korapaty, forecast a rally to end the year and begin 2024.

“I think that the selloff would not stick, meaning to the extent you see further selloff from here, you increase the risk of a sharper reversal in these yields,” he said.

The bad news is that the latest events in the Treasury market might serve as another cautionary tale from investors regarding the state of the country’s fiscal health.

The benchmark 10-year yield finished the Oct. 16 trading session at about 4.74 percent. The two-year yield firmed above 5.1 percent, while the 30-year bond inched closer to 4.89 percent.