U.S. National Debt Crisis: Bond Market Mechanics and Solutions

The national debt has surpassed $40 trillion, more than doubling in the last decade, fueled by increasingly large budget deficits. The government is spending more and bringing in less revenue than at any point in history, excluding major crises like recessions, pandemics, and World War II. This trend, coupled with new tax cuts and spending proposals, suggests the government has no intention of paying down this debt.

Adding to the complexity, other governments and major corporations are competing for the same lenders, driving interest rates worldwide to record highs. With debt also at record levels, borrowers need to borrow more just to cover their existing borrowing costs. This raises the critical question of who is left to lend money when everyone is deeply in debt.

This situation is leading to desperate measures, such as declarations of "economic D-Day" or attempts to "fight the bond markets." Governments are increasingly relying on complex financial maneuvers to manage the situation, making it crucial to understand bond markets and what happens when these tricks fail.

Understanding Bond Markets

To grasp the current crisis, it's essential to understand how bond markets typically function. The U.S. Treasury uses the Treasury General Account, a national checking account, to manage government finances. Tax dollars flow in, and federal spending flows out. For over 20 years, tax revenues have been insufficient to cover expenses, necessitating borrowing.

The government borrows money by selling IOUs with various maturities, ranging from 4 weeks to 30 years. These are categorized as:

• Treasury Bills: Less than one year maturity.
• Treasury Notes: 2 to 10 years maturity.
• Treasury Bonds: 20 to 30 years maturity.

The primary difference among these is the payback period.

Challenges with Long-Term Bonds

While the Treasury prefers long-term borrowing, two main issues arise:

1. Lender Preference and Illiquidity: Not all lenders want their money locked up for decades. Although long-term bonds can be sold in secondary markets, this is surprisingly difficult. New bonds are constantly issued, and the variety of existing bonds (different maturities, interest rates) makes secondary market transactions complex. This results in surprisingly illiquid secondary markets for long-term bonds.
2. Interest Rate Sensitivity: Long-term bonds are highly susceptible to interest rate changes. If you buy a 30-year bond at 3% interest and rates climb to 6%, your bond's market value decreases significantly. If you need to sell it before maturity, you'll incur a substantial loss. This dynamic was a key factor in the collapse of Silicon Valley Bank, which held many long-dated treasuries that lost value when interest rates rose.

The Yield Curve and Short-Term vs. Long-Term Debt

Typically, shorter-term bonds offer lower interest rates, a concept known as the yield curve. This is counterintuitive to personal finance, where short-term borrowing often carries higher interest. For government lending, shorter terms are generally cheaper.

However, relying solely on short-term debt means the government would constantly need to borrow new money to cover both fiscal shortfalls and maturing bills. This would increase the rate of turnover, making the government immediately vulnerable to interest rate increases. Currently, the weighted average interest on U.S. debt is around 3.1%, even as new treasuries pay 3.8-5.3%, because much of the debt was issued when rates were lower. Exclusive short-term borrowing would have made interest expenses double today.

The government balances different debt durations to achieve cost predictability and access various lender groups.

The Significance of the 10-Year Rate

The 10-year rate is crucial for two reasons:

1. Government Borrowing: It's the term over which the government does a bulk of its borrowing.
2. Consumer Lending Benchmark: Most major consumer lending (e.g., mortgages) is benchmarked against the 10-year rate. If banks can get 4.8% lending to the government for 10 years, they'll demand more from consumers due to higher default risk. The 10-year rate is used for mortgages because the average mortgage lasts about 10 years, despite being 30-year terms. Corporations also tend to borrow around this timeframe.

The government is keen to keep this rate low, especially around major political events.

Why the Bond Market Isn't Working

The bond market relies on three core assumptions: 1. America will make its repayments. 2. The U.S. dollar will retain its value. 3. There are no better lending options available.

The current spike in yields globally indicates these assumptions are being questioned. Several factors contribute to this:

Shrinking Domestic Lenders

• Government Trust Funds: Approximately $8 trillion of U.S. debt is held by government trust funds (e.g., Social Security). As more people draw from these programs than pay in, this buffer is shrinking, reducing a reliable buyer of government debt.
• Private Pensions: The decline of private pensions, replaced by individual retirement accounts, has reduced another significant pool of bond buyers.

International Investors Pulling Back

• Higher Foreign Yields: Some overseas investors can find higher yields from their own governments with comparable or better safety, without currency risk.
• Geopolitical Concerns: Other governments are reconsidering holding large amounts of U.S. bonds due to unpredictability in trade and potential sanctions. China, for instance, reduced its U.S. Treasury holdings to an 18-year low after observing sanctions against Russia.

Corporate Competition

• Internal Investment: Many major corporations, traditionally holding large cash reserves in Treasury bills, are now using these funds for AI development or issuing their own bonds, directly competing with Treasury offerings.

With fewer bidders for a greater number of bonds, the Treasury is forced to offer higher yields to attract buyers.

Desperate Measures

Treasury Secretary Scott Bessant recently attempted to use funds from the Treasury's checking account to buy old long-term bonds and Japanese yen. The goal was to increase demand for long-term bonds, thereby lowering their yields and, hopefully, the 10-year rate. This strategy, essentially day trading in forex and bond markets, proved ineffective, with rates quickly rising again.

While elevated interest rates can help control inflation, the current administration dislikes higher borrowing costs for the government, businesses, and voters. Their attempts to fix this might ironically worsen the problem.

Four Ways to Resolve the Debt

There are only four potential ways to resolve the national debt:

1. Economic Growth: Grow the economy and tax base faster than the debt. This is the ideal scenario, but with over a trillion dollars projected for interest payments this year, much of this growth would merely offset interest. Aging demographics and tax cuts further complicate this.
2. Fiscal Responsibility: Increase taxes and reduce spending to run a surplus or a smaller deficit. Many spending commitments are non-discretionary, and controllable categories like military spending are increasing. Tax cuts, especially for high-income earners and businesses, further reduce revenue. While some argue that taxing the wealthy wouldn't cover the debt, domestic lenders (wealthy individuals and institutions) are the primary buyers of government bonds, meaning they have the capacity to fund the government through taxes instead.
3. Inflate Away the Debt: The Federal Reserve could lower rates and print more money to pay off the debt. While an extreme scenario, the market is already anticipating a toned-down version. Inflation is already high, and spending isn't slowing. If lenders stop buying debt, the Fed might create dollars to buy it, devaluing the currency. Lenders, anticipating this inflation risk, demand higher interest rates, creating a vicious cycle where higher rates make it harder to grow or tax out of the debt, leading to more inflation and even higher rates.
4. Default: This is the least desirable option and is generally considered unthinkable for a major economy like the U.S.

Despite the current "unprecedented" talk, the U.S. has faced similar debt levels in the past. Understanding how those situations were resolved might offer insights into potential solutions today.