Where supply meets demand in the bond market

We have been very critical of lazy government decisions over the years. The governance of our tax dollars by our elected officials is misaligned (spend our tax dollars to get themselves re-elected as a glaring example, inability to make hard fiscal choices another).

We are now in a position in the U.S.A. where massive trillion-dollar deficits are the norm. Debt-to-GDP (gross domestic product) is projected to grow with no end in sight. This is not a new development. It’s been in the works for decades, but now, the percentage of debt held by the public is 100 per cent and historically, this has been a tipping point according to Reinhart and Rogoff. This book is 10-years old. These are secular trends and very long-term considerations. People have been screaming about fiscal prudence since democratic governance began hundreds of years ago.

From a supply perspective, the increased amounts of debt will need to be financed at a higher yield. It’s become clear under U.S. Treasury Secretary Bessent, that the U.S. needs to keep the cost of debt (read the 10-year bond yield) lower. Inflation is the death of financing this debt. We do not see any improvement in debt-to-GDP outlooks. The congressional budget forecast, in the chart above, paints a bleak picture and it does not forecast a recession in the next decade, which there will most certainly be.

From a demand perspective, a weakening economy and falling inflation are bullish factors for bonds. Hence a recession can help the demand side, but likely hurts the supply story at the same time. AI has significant disinflationary aspects in terms of improving worker productivity, but I’m in the camp where is net costs jobs and at least causes a significant skills mismatch for a generation. This aspect is inflationary and a burden on government social security safety nets to be sure.

Don’t look for bond yields to go back to a declining trend of what we saw in recent decades. The supply side will probably limit that aspect. But we could see short rates get back to two per cent or lower in the next recession. At five per cent plus, the long end of the U.S. Treasury curve (TLT ETF) is attractive if you are thinking that no job growth in the US over the past two years is signalling a weak economy ahead.

We see the recent back up in long bonds as a trading opportunity, but will reiterate that bonds are no longer likely the default “safe” part of your retirement portfolios. We have said here too for the past few years that private debt markets are likely a great alternative for many who understand the illiquidity aspect, but as we have seen some headlines recently, that sector has it’s own challenges around liquidity needs mismatches.