Myths and Reality

US fiscal sustainability myths and real risks to the Treasury market

At a time when US Treasury yields are rising to new highs I want to revisit an interview by Ruchir Sharma where he argues US budget is unsustainable and a bond crisis is coming. Sharm certainly talks some sense. But he’s wrong in several important respects. I too worry about the size of the debt in the medium term. But the immediate concern is the arrangements and timing of issuance. One can argue this a distinction without a difference. But there are mechanisms to counter the risks that arise from issuance which are not available for a true debt crisis. This piece attempts to highlight what I see as incorrect perceptions about the way the US funds itself and also point out the real risks in Treasury markets.

Early in the interview Sharma states: “there is no science is this”. Amen to that. We can agree on the numbers and still draw different conclusions. Composition is key!

What we have seen mostly, in recent bond market retreat, is adjustments to expectations of Fed stance and concerns about issuance of duration. Like Sharma, I believe the projected long-term annual deficit is a problem because it encourages inflation and misallocation of resources. It is mitigated by the government assistance to productive industry, which is reflected, partly, in high valuations of US equities. Consequently, I believe it is not the deficit per se, but how it reaches investors which is the problem. Any true international debt crisis is more likely to come from quasi-Treasury markets such as Gilts or French OATs than from Treasuries.

Diagnosis of catastrophe in the Treasury market seems ill-considered because the composition of sectoral balances in the US suggests there is leeway for absorbing the deficit. Sectoral balances also offers a self-balancing mechanism: corporate America can reduce its savings while Treasury reduces its borrowing. That is, of course, very bad news for equities, which is just the reverse of the current arrangement whereby government deficits aided equity valuations. But it is an internal mechanism available for rebalancing government borrowing that is not available elsewhere.

Sharma and I do both agree that nervousness is already heightened in the Treasury market at the point of issuance. For me, that is especially focussed on the cash/futures basis trade, which could form the crucial nexus of potential dislocation. The cash/future basis trade introduces fragility in Treasury market because it inserts enormous leverage into the primary issuance market; leverage owned by hedge funds and subject to unexpected disruption. That leverage has recently become subject to volatility. It is a signal of a potential problem.

Photo by Kenny Eliason on Unsplash

First let’s deal with structural issues, where I disagree with quite a lot of what Sharma says. Sharma makes the point that the US has been a fiscal outlier for 2-3 years in developed world budget deficits, but omits consideration of important aspects of US government borrowing.

If you believe, as I do, that Budget deficits should be judged within the context of overall sectoral balances, then it is important to recognise the US Current Account deficit is smaller than the budget deficit in recent years. That means US government borrowing recently relied on domestic US investors as much as foreigners. Yes, foreigners can cause disruption if they withdraw, but there seem to be willing domestic buyers if that happens. Sharma argues several times that the rest-of the-world is financing the US budget deficit when that is clearly not the case. There is no reliance on foreigners which usually precedes a debt crisis.

The federal deficit is about 6% of GDP and the Current Account deficit is about 3% of GDP. Half of the deficit is an internal savings transfer within the USA. That does not suggest a risk of investor rejection. The following chart shows how government deficit is largely accommodated by personal savings and corporate profits and NOT by foreign lending.

Indeed, the following chart shows that since 2004, the federal deficit is negatively correlated with foreign saving. In contrast, personal savings show a very strong correlation to deficits, as can be seen in the chart above. And corporate saving is another consistent offset. That suggests domestic buying (personal and corporate) is an important cushion.

Federal deficit vs. Foreign Saving, % of GDP correlation

How does such confusion arise? Well, I’m guessing but it may be because folks look at quarterly TIC flows and see there has been lots of foreign buying of Treasuries every quarter. They conclude that this shows foreigners are funding the Current Account deficit. But this misunderstands the dynamics of flow versus stock in overall national wealth.

The quarterly Current Account is simply not the best metric to use to assess long-term financial stability. As the IMF said long ago, “traditional measures of the current account may give a highly inaccurate measure of the movement of an economy’s net external wealth.” Instead, a better measure would take account of valuation changes in net assets and liabilities. The focus should be on the long-term balance sheet of the country, not the cumulative quarterly flows in the current account.

This means looking at the composition of the US Net International Investment Position (NIIP) over time, which reports the net composition of the United States balance sheet with respect to the rest of the world. The NIIP reveals quite a different dynamic. It is pretty clear from the overall composition of US liabilities that bonds have been superceded by equities as the major US liability to the rest of the world. In fact, bonds have not really increased much since the end of 2020, while equity liabilities have gone up by US$4.5 trillion. This is not well advertised despite being extremely important for conclusions about ‘fiscal sustainability’.

The same story is confirmed in the holdings tables reported in the TIC data.

We can only guess why this has been missed. It is not as if news of equity performance in the US has been absent. One possibility is the report of flows overstates the importance of bonds due to repeated redemptions. Stocks, in contrast, are effectively perpetual.

This is not unambiguously good news. Quarterly redemptions still have to be refinanced. Foreign buyers would be sorely missed. But the impact of equity liabilities to the rest of the world is to significantly reduce the consequences of debt liabilities. The international funding of the United States is now more reliant on equities than bonds. The US NIIP has been deteriorating consistently since before the GFC. As both the chart and the table above show, the deterioration is mostly (though not wholly) due to increase in portfolio liabilities in equity and investment funds. The biggest driver for this increase is not increased buying of US equities by foreigners. Instead it has been market outperformance of the US stock market relative to foreign stock markets. This drives up US liabilities to foreigners who hold US stocks.

The funding of cumulative US liabilities to the rest of the world, including accruing trade deficits, has been met, in large part by appreciating price of US risk assets more than by issuance of debt. The mechanisms for payment of trade deficits by appreciating asset prices are complex, but they exist. It is similar to a country finding a new source of gold, or oil.

If the S&P500 were to fall sharply, it is possible (indeed likely) that the US net international investment position would IMPROVE because the liabilities owed to foreign stock owners would decline.

Of course, that doesn’t mean the foreign ownership of Treasury debt is irrelevant. But it is not as important as many argue. Why, because the composition of NIIP reflects an important political relationship between US fiscal deficits and US stock performance that may be unique in the world. It is an arrangement that counters concerns about fiscal crisis, unlike arrangements elsewhere in the developed world.

The US government is intimately bound to US stock market success. Over time this relationship means the US effectively runs an industrial policy. The Inflation Reduction Act was not the first to divert government finance into the corporate sector. Tax cuts and direct investments in ‘essential advanced technology and infrastructure’ have been important for decades. Spacex, owned and managed by Elon Musk, an important member of the incoming administration, is a well-known private sector recipient of US government funding. There are many others. To the long list of the US industrial complex beholden to government support we need to add numerous incentives. These include the regulatory freedom applied to the tech sector in the US - exempt from many regulations applicable to legacy media and industry and especially distinct from regulations applicable in other parts of the world. GDPR is not going to be instituted in the US. These all encourage investment and risk taking in the US that is not available elsewhere.

The result is the US sustains an ecosystem for the private sector development in advanced technology of which other countries can only dream. In sectoral balance terms, these relationships form the other side of the corporate/federal savings nexus mentioned above.

One reason the corporate sector runs huge surpluses (savings) is because it functions as the counterpart to the government deficit. That corporate surplus is also the foundation for innovation - and a buffer that allows failure in innovation, meaning more corporate creativity is permitted. Microsoft’s investment into nuclear energy, and AI, is underpinned by its massive savings. The federal deficit is a partial counterpart to this investment buffer across the corporate sphere. Foreigners gain from this relationship because, as we have seen, US equities have responded positively to extended goverment largesse and innovation, which in turn increases foreign liabilities. Of course, that also means that any substantial reduction in US government deficits also risks undermining corporate surpluses - and therefore equity prices and possibly innovation. Work by the new DOGE department charged with reducing government spending will have to tread carefully if it is not to undermine the interests of its leaders like Elon Musk.

That is not to say that rising federal deficits are not a problem. We will come to that shortly. But before we do, let’s look at some of the other claims Sharma makes. He implies that as reserve currencies usually last 100 years and the dollar has been ascendant for nearly a century it is time for a change. Well, the decline of a dominant reserve currency historically has been decided by the relative attractions of its replacement rather than the profligacy in the incumbent. The end of reserve dominance of a currency depends on a viable alternative to adopt as replacement. There is currently no viable replacement. Unfortunately, that is not an unalloyed benefit because the lack of a ready replacement for the dollar means there is no real constraint on US profligacy - indeed it’s pretty clear that global demand for US assets actively encourages US profligacy. If US asset prices continue to rise they will meet the funding demands of trade and fiscal deficits - albeit with some potentially disruptive political economy arguments along the way.

Sharma also fails to give enough weight to reserve incumbancy in other ways. For instance, he argues that the US should heed the warning of other developed economy bond markets - particularly the UK and France which have recently shown sensitivity to unmanageable deficits. Unmanageable deficits is a problem for all government bond markets eventually. But the question for the Treasury market is where the boundaries lie. We can be confident that the boundaries applied to the UK and France are considerably more constrained that for US Treasuries. A disturbance in a lower status market is not a prediction for the bond market of the dominant reserve currency.

UK and France are able to run relatively large deficits because they are quasi proxies for US Treasury bonds - as I argued here. But both France and UK are inferior proxies in many ways - something I omitted to address in the earlier piece. Their bonds are denominated in non-dollar currency and their markets are less liquid. They may also suffer from a faster erosion of percentage of world GDP, worse demographics, less attractive regulatory environment and (incredibly) greater dysfunction in their polity - especially alienation of voters for the entire political apparatus. The total cost of this is reflected in the lower historic returns and likely lower future returns from these bonds, in dollar terms. That’s the direction of travel has happened since Trump’s election.

So, where do Sharm and I agree? Firstly, large fiscal deficits and outstanding debt is an a very poor allocation of resources. Which is another way of saying it leads to inflation. Which is probably another way of saying it leads to wealth inequality - despite protests from Democrats - especially in conjunction with the government/corporate nexus which exists in the USA.

We also both agree that the issuance process is a major point of fragility in the Treasury market. In fact, I think Sharma actually understates the risks. He points to auction size and frequency as a potential stumbling point for the Treasury market. But he doesn’t identify the main point of weakness, which is the immediate capacity constraint on issuance in Treasury market dominated by cash/futures basis trade. Especially as 2025 will face an enormous amount of issuance, and most likely a move away from the short-term Treasury Bill issuance favoured by Janet Yellen.

That introduces a potentially fragile link between Treasury issuance and end investors. And that link has become increasingly mediated by hedge funds, who hold approximately US$1 trillion of cash bonds against short futures positions while asset managers (the traditional buyers of bonds) favour holding long futures positions. I’ve covered this trade before.

The combined exposure to the cash/futures basis trade has reduced since Donald Trump won the presidency. In late October 2024, the outstanding net short value of all UST futures stood at nearly US$1.2 trillion. Latest data suggest it has fallen to just over US$1 trillion. That seems appropriate (in direction anyway) because the incoming government looks likely to shift issuance away from the short end (see another piece I wrote here).

Cash/futures basis is susceptible to repo disturbance and balance sheet constraints (both of hedge funds and of banks offering repo). Reduced exposure to the trade is also appropriate because these natural choke points in funding for the cash/futures basis have been revealed at year-end 2024. Repo levels rose far above the theoretical limit suggested by the Fed’s Standing Repo Facility, which suggests the central bank momentarily lost control of short-term money market at the end of last year. That has worrying implications for risk management in the cash/futures trade.

The combination of rising issuance (due to redemption profile as well as continued fiscal incontinence), cash/futures basis is likely to introduce significant risk to the Treasury market in 2025. But this is a specific funding risk which may be mitigated by authorities such as the Fed offering additional temporary assistance. We are a long way from a fiscal crisis in the US. But issuance concerns are paramount.