WILL BOND VIGILANTES COME FOR AMERICA´S NEXT PRESIDENT? / THE ECONOMIST

Will bond vigilantes come for America’s next president?

Treasury yields are rising ominously

With just days left before America’s presidential and congressional elections, market participants are abuzz with discussion of what the various results might mean for everything from trade and defence to tax and regulation. 

But the Treasury market, which ultimately underpins much of global finance, is of particular interest.

Some investors think political risk is already interfering with the world’s largest bond market. 

Ten-year Treasury yields have climbed in the past six weeks, from 3.6% on September 16th, the lowest in almost a year and a half, to 4.3%. 

Market volatility has risen to its highest this year. So far the evidence, on balance, suggests political panic is playing a relatively small role. 

As America’s debt levels keep rising, that may change.

If either party wins a clean sweep—gaining the presidency as well as majorities in both houses of Congress—there will be a limited check on its fiscal ambitions. 

The Economist’s election model finds that the chance of this happening is greater than 50%, with the Republicans more likely to achieve a total victory. 

Donald Trump’s recent suggestion that he could abolish income tax in favour of revenue from tariffs has been the most absurd proposal, but both presidential candidates have made chunky and unwise pledges on tax and spending.

Even without a rush of additional spending, America’s deficit is forecast to run to an average of 5.5% of GDP over the rest of the decade. 

A greater share of Treasury issuance is now made up of bills—short-term bonds—meaning that the scale of the borrowing will be particularly large, as the debts need to be refinanced more regularly.

How will the market bear up? 

Analysts fall into two broad camps. 

Some have bond vigilantes on their mind, believing that investors are waiting to bring Washington’s largesse to an end. 

Others think that worries about a panic are overstated: although the effect of new issuance may not be zero, it is small relative to the effects of inflation and economic-growth expectations. 

The Treasury market is already the most liquid debt market in the world; an inflow of new securities does not move the needle much.

Both groups can claim some support from the recent market sell-off. 

The term premium—a measure of the compensation that investors demand for taking on all manner of risks related to growth, inflation and intangible political concerns—has accounted for most of the rise in yields. 

It has increased from around -0.3% on ten-year bonds in the middle of September to 0.2%. 

Investors really are becoming more cautious.

But the measure is still barely positive, and sits far below where it was during previous periods of worry. 

For most of the time from 1980 to 1995, when investors were concerned by surging inflation, and then the risk of rising federal debt, the term premium accounted for between two and five percentage points of the yield on a ten-year Treasury bond.

The historical evidence provides further reasons for calm. 

In May Christopher Gust and Arsenios Skaperdas, both of the Federal Reserve, published a review of the evidence on the impact of rising government debt on long-term bond yields. 

Across nine studies, an additional percentage point of debt, relative to GDP, was estimated to raise long-term interest rates by between 0.01 and 0.06 percentage points. 

By the end of the decade, America’s debt-to-gdp ratio is set to rise by eight percentage points, which would imply a rise in long-dated yields of between 0.1 and 0.5 percentage points. 

Although the second outcome would be unwelcome, the first would be difficult to notice at all.

Yet Messrs Gust and Skaperdas also offer an important caveat: with American peacetime debt near its highest-ever level, history may not offer a reliable guide to what is to come. 

Moreover, the Treasury market is heading into uncertain territory. 

At the beginning of next year the federal debt ceiling will be reinstated unless lawmakers act. 

America may therefore risk a default once again, especially if the new government is a divided one.

Sclerosis in American politics means that it is unwise to be relaxed about the coming Treasury issuance. 

As the stock of debt grows, small shifts in America’s interest payments will make an increasingly big difference to the annual bill. 

If the bond vigilantes do appear, the experience will be more painful than in the early 1990s. 

America’s next president will inherit a great economy. 

The financial situation is a little hairier.