U.S. Budget Deficits, Debt and the Return of Bond Vigilantes

By the Curmudgeon with Victor Sperandeo


Record U.S. Budget Deficit and Interest on National Debt:

The U.S. budget deficit soared by 40% in the 1st quarter of the government’s fiscal year. Between October and December 2024, U.S. federal government spending exceeded revenues by $711 billion and set a record. Spending soared by more than 10% to ~ $176 billion.
 

Interest on the national debt was $20 billion or a little over 13% of total government spending.  At $36 trillion, the stated U.S. debt easily exceeds the size of the U.S. economy.  In 2024, the debt is projected to be $29.167 trillion and is climbing parabolically as per this chart):

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What stock market pundits don’t seem to realize is that with interest rates on U.S. notes and bonds on the rise and approaching 5%, and possibly headed higher, the debt service costs will increase tremendously.  That will make it even more difficult to reduce sky high U.S. budget deficits and debt servicing costs.

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The Return of Bond Vigilantes:

Martin Barnes, a former chief economist at BCA Research, told Barron’s this week that he expects bond vigilantes [1.] to return, forcing the U.S. government to pay a fiscal risk premium on its debt. It’s unknown when they will exact that price, even though U.S. total government debt exceeds 120% of GDP which hasn’t set off alarm bells yet.

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Note 1. The term “bond vigilantes” refers to investors who discipline excessive government spending by going on a “buyer’s strike,” thereby demanding higher U.S. debt yields. In the early 1980s, when strategist Ed Yardeni coined the term, bond vigilantes surfaced when U.S. budget deficits increased.  Since then, episodes of fiscal excess regularly gave rise to questions about when those vigilantes might return.

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The bond market “is likely to price in more uncertainty because of the inherent contradictions among many of Trump’s policies, the volatility around their application (for example tariffs), and still-too-large budget deficits,” according to Steven Blitz, chief U.S. economist of TS Lombard. 

Blitz thinks 10-year Treasury yields could climb to 6%, a level not seen since mid-2000. That’s especially true if the Fed ends its rate cuts and lifts the fed-funds rate to 5% to 5.25% in two years, from the current target range of 4.25% to 4.5%.

U.S. note and bond markets are waiting to see the impact of Trump's tariff, immigration policies, spending cuts and tax reductions.  Disappointments in any of those could trigger the vigilantes. Persistent wrangling over the U.S. debt ceiling, further downgrades to the U.S. credit rating or a fall in foreign demand for U.S. Treasuries due to reasons like sanctions and wars could make matters worse.

"There are many possible sparks," said Ray Dalio, the founder of macro hedge fund firm Bridgewater Associates, in an email to Reuters.

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Victor’s Comments on U.S. Note and Bond Yields:

In my opinion, U.S. Note and Bond yields are far too low considering the level of U.S debt to be auctioned continued gargantuan government spending. The net result is likely to be declining Treasury note/bond prices and higher yields. 

Several factors point to 7%-to 8% yields on 10-year T-Notes this year and certainly beyond. That’s largely based on the Trump administration’s stated fiscal policies, which would increase inflation and the budget deficit.  However, President Trump’s pronouncements are either exaggerated, wrong, or he is intentional not telling the truth when talking to the public. Also, he may change very quickly, and Congress may not approve his agenda (it can’t be all based on Executive Orders).

Robert Rubin, Bill Clinton's Treasury Secretary and a former co-chairman of Goldman Sachs, said the bond market "could very quickly make it very difficult" for Trump to do what he wants if a steep rise in interest rates triggered a recession or financial crisis. "Unsound conditions can continue for a long time until they correct, rapidly and savagely. When the tipping point might come, I have no idea," he said.

While a recession would certainly lower U.S. yields, the Congressional Budget Office (CBO) assumes no recessions in the coming decade.   Not counting the 2-month COVID caused GDP decline in 2020, there has not been a recession since the last one ended in June 2009.  One might ask if the business cycle has been repealed?

Comparison of U.S. Note/Bond Total Returns:

Until recently, the total return on 5-year T-Notes did not suffer an annual loss from 1970 to 1994 (and then again in 1999).

Total returns on the U.S. notes during the great inflation from 1968 to 1981 were positive due to the yields being high enough to offset the declines in price.

The 30 year bond total returns from 1977-1980 were: -0.69%, -1.10%, -1.23%, and -3.95%, according to Ibbotson Associates, which has discontinued publishing this data in 2023. Sad as they had compiled those results since 1926.

In comparison, the iShares 3-7 Year Treasury Bond ETF (IEI) declined in price from 12/1/20 to 12/1/24.  According to Blackrock, its 3 and 5 year total returns through 12/31/2024 were -1.31% and +.003%, respectively.

Moreover, the % of yearly note 5-year T-Note futures prices declined four consecutive years from 2021-2024. Futures are a much better guide than using spot prices, as they take into account inflation and the maximum tax rate of federal income taxes paid on yield.

Using the iShares 20+ Year Treasury Bond ETF (TLT) for a guide to U.S. Treasury bond declines ...in the last four years TLT’s price decline was -42.23%!  The 5-year chart of TLT below shows the price is testing a bottom it made in November 2023:

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U.S. Inflation Trending Higher Since Sept 2024 Jumbo Fed Rate Cut:

In an apparent slap in the face to Fed Chair Jerome Powell, U.S. inflation has risen in each of the last three months since the September 2024 50bps rate cut which we opined was not needed.  Here’s a one-year CPI chart courtesy of Trading Economics:

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It’s hard to believe the Fed will achieve its 2% inflation target any time soon and therefore will likely be on hold for the foreseeable future.

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Victor’s Conclusions:

From June 1971 to June 2024, U.S. debt grew at a compounded annual rate of 8.81%. At that rate, the national debt will rise from $36.3 trillion to $84.5 trillion in 10 years!!!

The CBO says it will be +$60 trillion without a recession or tax cuts!  A year ago, CBO projected it at $54 trillion.

Until we see significantly less government spending -not just proposals and amorphous talk - U.S. debt markets will continue to erode as the bond vigilantes return. 

End Quote:

After Trump was elected President in November, market sentiment is implicitly related to a song from the 1987 movie “Mannequin” by Jefferson Starship’s great singer Grace Slick with Mickey Thomas. It’s titled, “NOTHING GONNA STOP US NOW.” The lyrics have a strange association today:

l  Looking in your eyes I see a paradise

l  This world that I've found is too good to be true

l  Standing here beside you, want so much to give you

l  This love in my heart that I'm feeling for you

l  Let 'em say we're crazy, I don't care about that

l  Put your hand in my hand baby, don't ever look back

l  Let the world around us just fall apart

l  Baby, we can make it if we're heart to heart

l  And we can build this thing together

l  Standing strong forever

l  Nothing's gonna stop us now

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Stay healthy, success and good luck.  Till next time……………..

 

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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