The bond market has been all over the news in the last two weeks. Bonds are signaling higher interest rates. Second, the bond market is highlighting the long term financial problems in the US economy at the federal level and our inability to solve them. The “bond market” is a collection of financial institutions that buy, sell and speculate in debts from governments and corporations.
The bond market is in the news because it is one of the best predictors of US economic health. Bond prices are one of the key indicators of the US economy along with the GDP, the employment report and corporate profits.
Bonds, the bond market, and the national debt rarely get attention in the press; however, lately everyone is paying attention. U.S. government bonds are an important part of the US economy. They represent the federal government borrowing, while state and local governments issue their own bonds.
When bond prices fall, bond yields and interest rates rise. Higher interest rates affect both consumer spending and business profits and investments. Let’s look at some of the reasons for bond market volatility, media discussions and the impact on the average consumer.
US Debt passes $40 Trillion dollars
In July, the total US federal debt passed $40 trillion dollars, or 135% of GDP. The central question is whether the federal government has the political will to reduce the debt by either increasing taxes or cutting spending to repay the debt. Or when it is necessary. The US will never default on its bond loans. A default would destroy the global financial system; the issue is how much debt is too much debt.
The current US debt is about $120,000 per person. The bond market is concerned that interest rates will rise because of inflation, and politicians have no desire to reduce the debt by cutting spending or raising taxes. Biden’s COVID spending and Trump’s tax cuts both added significantly to the debt.
But it gets worse: the US population is getting older, while the number of income taxpayers is falling, lowering tax revenues. Social Security and Medicare are funded by working taxpayers.
Older people expect Social Security and Medicare benefits. In addition, fewer taxpayers, both now and in the future, are available to support government borrowing. Taxpayers are also paying less in income taxes, particularly among higher-income people. Defense spending is at record levels, while government debt service payments keep growing.
Does the size of the debt matter?
At some point, the size of debt matters, but no one knows when? Eventually, interest payments on the debt crowd out other spending. Economists are completely undecided about what level of debt actually harms the economy. Economists disagree about how much debt is too much and, more importantly, under what conditions debt begins to harm economic growth and social programs. When does the debt affect the economy, reduce growth, corporate profits,s or consumer spending? No one knows.
For comparison, Japan has a national debt of around 230% of GDP, while France is 115% and the UK is 100%. Switzerland has a debt-to-GDP ratio of 40%, and Germany has a ratio of 60%.
The original idea of debt is to make investments you cannot currently afford now that will ultimately return a payoff greater than the debt costs. Debt is for investments. For example, a mortgage, an educational loan for a doctor, a school, a bridge or a mass transit station. Instead, the debt is being used to fund tax cuts, social programs, and operating expenses.
So what does the bond market signal about the US economy?
First, it points toward higher interest rates throughout the US economy. The bond market has seen increased inflation and few limits on government spending. These fears trigger a demand for higher yields from bond payments to cope with future uncertainty. So, as a result, bond prices drop, yields rise and interest rates rise.
Over the long term, rising interest rates lower consumer spending power and corporate profits. Both groups are paying higher rates to borrow money. Consumers spend more on mortgages, credit cards, and car loans and less on personal consumption. Businesses spend more on debt service and less on investments. Business profits are reduced because of higher interest payments for debt service.
The bond market sell-off was started by the debt hitting $40 trillion dollars. An expected figure to many in the financial community, but also understandable to the larger public. When the larger public understands the debt and what it takes to reduce it, they expect higher taxes and cuts to future social programs. People react by cutting personal spending, which is the heart of the US economy (70% of GDP). The uncertainty over public finances has raised the borrowing premium and, with it, interest rates.
Media Coverage of the Debt
The media coverage was heavy but quickly moved on. The media coverage strongly shapes the public understanding of the debt, the deficit, and possible solutions. Much of the US media reporting simplified the issue rather than providing detailed discussion of this complex issue.
Much of the coverage treated debt and financial issues as political gamesmanship rather than an opportunity to explain the underlying economics. Scott Bessert made appearances on the Sunday morning talk shows, while President Trump made a statement and moved on.
So what are bonds?
Let’s look at basic bond economics
Bonds are a basic debt instrument. They are long-term loans that pay an interest payment called a coupon for the loan. Bonds are less risky than equity shareholder investments because legally bondholders have a first claim on corporate assets in a bankruptcy or liquidation and owners have the last claim.
There are several different types of bonds. The best known are US Treasury bonds including T-Bills, 10-year and 30-year Treasury bonds. There are municipal bonds issued by cities and states to fund public projects like school buildings and roads. Corporate bonds are loans to companies. And there are high risk bonds called junk bonds.
Bond Pricing
Let’s look at some basic bond economics. Bonds are debt instruments like mortgages, credit cards, or car loans. Bonds are priced based on a borrower’s ability to repay the debt. Apple sells bonds at a 1% interest rate while junk bonds trade at 12%. The odds of being repaid by Apple are much higher than by Junk bonds from Joe’s car wash. This is the risk premium.
Bond prices move opposite to interest rates. Bonds’ return a fixed amount of money as interest payments during the term of the loan. The amount is called the coupon or interest payment.
The stream of interest payments is called the nominal return. A one-year, $1,000 bond with 5% interest rate returns $1,050 dollars after one year. $1000 for loan repayment plus $50 in interest. A two year bond has a nominal return of $1,102.50 after two years, assuming you can invest the $50 interest payment from year one at the same 5%. The higher return, $2.50, is due to compound interest.
One thousand dollars in a ten-year bond at 5% interest rate would yield $1,629 dollars after ten years. $1000 in loan repayment, $500 in earned interest and $129 dollars in compound interest.
In a zero inflation environment, the bond interest rate, the nominal return and the yield on both the 1,2, and 10-year bonds would be 5%.
Now add inflation and rising interest rates
Now, let’s add in inflation or rising interest rates. Inflation reduces the value of the future payments. If inflation is 3%, then the value of the future payments is reduced by 3% because everything in the future costs more. The yield is no longer 5%; instead, it’s a 2% return (5% interest – 3% inflation = 2% yield). A bond that yields a 2% return is worth a lot less than a bond that yields 5%. So, in an inflationary economy, investors expect higher yields; existing fixed-rate bond prices fall and interest rates rise.
The expectation of rising interest rates works the same. If investors expect interest rates to rise from 5% to 7%, then current fixed rate bond at 5% are worth less. Investors can buy a new bond with a higher yield, 7%, so the demand for 5% bonds drops and so does the price. In the real world bond market, bonds sell at a discount based on inflation and interest rates.
Inflation and higher interests rates show up in the bond prices first before the rest of the economy. But the effects of inflation and increasing interest rate ripple through the US economy over time. The bond market is a predictor of the US economy. That explains the huge media and public interest in the bond market.
Right now, the current inflation rate is 3.4% as measured by the BLS. The benchmark for bonds is the US Government 10-year Treasury bond, currently yielding 4.79% and the 30-year Treasury bond with a yield of 5.25%. Corporate bonds have different risk classes with different yields, such as AAA (10-year 5.18%) or BAA (10-year 6.85%).
Solutions
There are solutions to the debt problem, but none are easy. All the answers to fix the debt issue lead to a lower standard of living for most people. The idea of debt is to make investments you cannot currently afford now that will return a payoff greater than the debt costs. For example, a school, a bridge or a mass transit station.
First, in theory, you can grow your way out of debt. As long as the deficit, current-year additions to the national debt, is shrinking, the federal government will eventually pay off the debt. Easy answer, hard to do.
Or you can try austerity, like the UK, with large cuts to social programs and government spending. Also hard.
Or tax increases. Politically hard to do.
Or you could devalue or default. Some bondholders would have to take a “haircut.” Impossible.
All the solutions are painful to some group of voters. Greece and Argentina went through long periods of painful readjustment as they learned to live within their means.
Summary
The bond market provides fundamental insight into the US economy over the long term. US Treasury bond prices are one of the few financial indicators politicians pay attention to. The bond market is saying the US government has a long-term financial problem. Get ready for higher taxes or benefit cuts.