The United States government is losing fiscal discipline and bond markets are waking up by pushing Treasury yields higher.
The recent sharp jump in US Treasury yields has reverberated into global equity markets, as investors price in higher interest rates. The 10-year yield touched a four-year high of 2.88 per cent Friday morning AEDT, helping push down the Dow Jones Industrial Average more than 2 per cent in intraday trade in New York.
The rise in yields in recent weeks has been primarily driven by stronger economic growth and inflation expectations, but analysts are also pointing to a deteriorating US federal budget as a secondary factor.
Franklin Templeton fixed income portfolio manager Michael Materasso said there would be greater supply of government debt just as the US Federal Reserve reduces demand for bonds as it unwinds its quantitative easing program.
"I think there is a concern that fiscal discipline has taken a back seat," he said.
"There are other factors that are more immediate on interest rates, but I think it's a marginal factor at this point."
A proposed two-year Senate budget deal this week to increase government spending by $US320 billion, chiefly for the military and disaster relief, does nothing to address the US government's ballooning $US20 trillion-plus debt. The bipartisan compromise, still requiring ratification by the more sceptical House, will add $US1.7 trillion to the deficit over a decade.
As lawmakers were hammering out the budget breakthrough to avert a government shutdown, investor demand was weak at a $US24 billion US 10-year note auction Thursday AEDT, with a bid-to-cover ratio of a mediocre 2.3 per cent.
Bond yields immediately shot higher.
In conjunction with the recent $US1.5 trillion debt-financed tax cut for the next decade, the US federal debt is on track to balloon to around 100 per cent of gross domestic product by 2027.
Republicans were deficit hawks in opposition for years when the lacklustre economy most needed fiscal stimulus in the wake of the 2008-09 financial crisis. But under a populist and fiscally-undisciplined former real estate mogul as President, Congress is loosening the purse strings just as the economy heats up and hits full employment.
The greater issuance of Treasury debt to finance tax cuts and spending comes just as the Federal Reserve – and potentially soon other central banks – winds down its $US4 trillion balance sheet and has become a net seller of Treasury bonds.
Over the next two years the Fed will allow $US1 trillion of maturing bonds to roll off its balance sheet - $US600 billion in Treasurys and $US400 billion in mortgage-backed securities.
The higher yield demanded by bond investors may partly explain why the US dollar has been unusually weak over the past year, even though bond yields have paradoxically risen.
In a Federal Reserve interest rate tightening environment, yields and the greenback would usually have a positive correlation.
Treasury data shows China and Japan, the two biggest foreign holders of US Treasurys, have been net sellers in recent months.
Nobody is suggesting the US is at risk of default – credit default swaps price that possibility at virtually zero.
BNY Mellon Wealth Management head of fixed income John Flahive said the rise in yields was due to higher economic growth expectations in the US and globally. He "doesn't buy" that rates are going up to due a loss of fiscal responsibility.
"The United States still has the engine of growth to handle higher deficits to grow our way out of the problem unlike some other countries such as Japan that doesn't have the demographics," he said.
The US enjoys the unique benefit of having the world's reserve currency, which is attractive to investors due to liquidity and safety – helping keep a lid on yields.
President Trump wants to add at least $US200 billion of public money into infrastructure to reach a $US1.5 trillion infrastructure goal over 10 years, funded by the government and private sector.
Maya MacGuineas, president of the Committee for a Responsible Federal Budget, said Congress was adding hundreds of billions of dollars to the nation's credit card.
"It's one thing to have trillion-dollar deficits during a deep recession, but to create permanent trillion-dollar deficits projected during a time of economic expansion is the definition of irresponsibility," she said.
"That there is virtually no discussion of how to control the fiscal situation shows just how broken our governing process has become."
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