Thursday, August 24, 2023

Maybe The Real Reason Bond Prices Are Dropping Is...

 Analysts are somewhat baffled by the drop in bond prices.  Inflation is moderating and the Fed is sending "hold" messages. So what is driving bond prices to 20 year lows?

Maybe - just maybe - it's the oldest reason in finance: creditworthiness.  After all, Fitch just downgraded the US from AAA to AA+. 

Just how creditworthy is the US? 

In just 4 years the US has raised its gross Treasury issuance from $12 trillion to a projected $21 trillion in 2023. Yes, it's not net issuance (ie after maturities/debt retirement), but bear with me for a bit.  Gross issuance has gone from 50% of GDP in 2018 to 77% of GDP in 2023P - see charts below.

Why am I choosing gross issuance instead of net? Because if the US were to become less creditworthy (and it arguably has) some lenders could balk at rolling over their existing bond investments and/or demand a higher return.

I think this is exactly what is happening right now: increased supply (more gross issuance) is starting to face demand headwinds causing prices to drop.

Gross bond issuance is also a measure of debt service stress.  Since the government is running massive budget deficits, it has to issue debt to cover that plus interest payments.  And as interest rates rise, so does the amount of new debt required to pay just interest.

Take a look at the chart below: in just a few months, the federal government's annual interest payments have soared from $500 billion to nearly $1 trillion.  

Is this sustainable? Is it compatible with even a lower AA+ rating?  From one perspective, it is: interest payments as a percentage of GDP have jumped from 2.5% to 3.6% (1Q23), but still well below the highs of the 1980s - see chart below.

Interest Expense as % of GDP

However, when we look at the budget deficit, things become scarier - see chart below.  The FY 2023 deficit is projected to reach well over $1.5 trillion, perhaps even reach $2 trillion.  In just the first 9 months from October 2022 to June 2023 the deficit stood already at $1.4 trillion, fueled in large part by the soaring interest expense discussed above.

US Federal Budget Deficit (FY 2022 Last Point On Chart)

In sum, the US government finances are, in a word, unsustainable. Unless:
(a) the budget deficit is slashed and,
(b) interest expense comes sharply down
even the AA+ rating is very generous, optimistic and likely to go lower quickly.  In my opinion, Fitch's action is a first warning - I bet they wanted to go lower but chose to be politically cautious, at first.

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