Here’s Why 10%+ Treasury Yields Are a Real Possibility

John Mauldin  |

The US Treasury has closed the books on Fiscal Year 2018, which was another debt-financed failure.

The federal government spent above $4.1 trillion in FY 2018. It had to borrow $779 billion on budget and a few hundred billion more off-budget.

And over 40% of the on-budget deficit went simply to pay $325 billion in interest on previously-issued debt.

Obviously, the government should spend less. But where to cut?

There is no political agreement on that and little prospect of one. Nor is it likely that are we will grow out of this. So, I expect even bigger deficits.

Here we run into a bigger problem.

The Treasury’s Lenders Are Turning Away

Deficits mean the Treasury has to borrow cash. It does so by selling Treasury bills, notes, and bonds. This wasn’t a problem for most of the last decade. But it is quickly becoming one as the amounts grow larger.

This is due to the “exorbitant privilege” I discussed earlier this month. The US has long had many foreigners willing to buy our debt.

Now they are losing interest because hedging their currency exposure costs more. There are some complex reasons behind this, but here’s the bottom line:

European and Japanese investors can no longer buy US Treasury debt at a positive rate of return unless they want to take currency risk, which most do not.

This is a new development.

This might be fine if US investors made up the difference.

But that’s not happening, either. And it might not be great anyway.

Capital that goes into Treasury debt is capital that’s not going into bank loans, corporate bonds, mortgages, venture capital, stocks, or anything else in the private sector.

This is the capital that generates the growth we’ll need to pay off the government’s debt.

Last month’s two-year note auction matched the lowest bid-to-cover ratio for that maturity since December 2008, according to Bloomberg,

The problem is manageable for now. And Treasury will always be able to borrow at some price… But the price could get much, much higher, with interest costs rising through the roof.

Given the debt’s maturity structure, it could be sooner than you might think.

There Are Two Scenarios—Neither Will Be Fun

Treasury took advantage of lower short-term rates in recent years. This reduced interest costs, but also created refinancing risk.

Looking only at federal debt not held by the Federal Reserve, Treasury will need to borrow something like 43% of GDP over the next five years just to rollover existing debt at much higher interest rates.

That’s not counting any new debt we add up. It could be quite a lot if we enter recession or (God forbid) another war.

Aside the hypothetical possibilities, Social Security and Medicare are enough to blow up the debt.

Somebody has to buy all that Treasury paper. If it’s not foreigners, and not the Fed, and not American savers, we are out of prospects.

Now, buyers will appear at the right price, i.e. some higher interest rate. Barring recession-induced lower rates (which would be a different problem), government borrowing could get way more expensive.

Which is more likely: a double-digit ten-year Treasury yield or a worldwide debt liquidation? Neither will be fun. But I’ll bet that we see one or the other at some point in the 2020s.

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