Transcription
As you probably already know, America's public finances aren't in great nick at the moment. The overall debt burden stands at over 100% of GDP, the deficit at about 6%, and neither look like they're going to get better anytime soon, especially if Trump gets his 1.5 trillion dollar defense budget.
However, on Wednesday evening, things suddenly got a lot worse with the yield on 30-year bonds suddenly spiking to their highest level since 2007, just before the financial crisis. So, in this video, we're going to explain what just happened and what it means for the US.
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So, to understand this story, you need to know a little bit about how bond markets work. We've been through this before in previous videos, but for the benefit of new viewers, the TLDR is that when governments borrow money, they do it by issuing bonds. Bonds are essentially defined as three things: the face value, that's how much the bonds cost in the first place, the coupon, that is the annual interest rate that whoever owns the bond receives, and the maturity, that is when the bondholder is paid back the full face value of the bond.
To give an example, the US Treasury might issue a bond with a face value of $1,000, a coupon of 5%, and a maturity of 10 years. If you bought that bond off the Treasury, you would basically lend the US $1,000. The Treasury would pay you $50 a year for the next 10 years, and after 10 years, they'd return the whole $1,000.
Importantly, however, the effective annual interest rate or yield of a bond can change if markets decide that they don't want to pay the face value. So, for instance, if I tried to resell that bond that I just bought, but the markets are only willing to pay a face value of $900, whoever bought that bond would effectively be paid a higher yield. After all, $50 is more than 5% of $900. It's more like 5.5% and after 10 years, this new bond holder would also get an extra $100 because the Treasury would pay back the full $1,000 face value. But, this new bond holder only bought the bond for 900. This means the effective yield would actually be over 6%.
This would be bad news for the Treasury because it would imply that the US would now have to offer bonds with coupons over 6% to attract new buyers. This is essentially how governments decide what coupon to offer on new bonds. They look at the effective yield of already issued bonds and then offer effectively the same rate.
Anyway, the key thing to understand for the purposes of this video is that in relatively safe bond markets, like those in the US, the yields on short-dated bonds generally track interest rates. The basic idea here is pretty simple. Interest rates dictate how much money you can make by storing your cash in totally risk-free savings accounts. So, if the government wants anyone to buy their short-term debt, which is nearly risk-free because you can be pretty sure that the government isn't going to default in, say, the next 3 months, then they have to offer ever so slightly higher rates.
The yields on long-dated bonds, however, are more interesting and are essentially defined by two things. One, how likely the market thinks you are to end up defaulting and two, how much inflation they expect. If the market expects lots of inflation, then they'll demand higher yields to compensate because higher inflation will reduce the real value of any interest payments, as well as the face value which you get back once the bond matures.
And well, this is the main reason that yields on long-dated Treasuries suddenly spiked to a 19-year high on Wednesday. This was in part because Trump said earlier in the day that he would be hitting Iran hard, reviving fears of a prolonged conflict in the Middle East and the inflationary impact of higher oil prices. But it was mainly because of a Federal Reserve meeting that happened in the afternoon.
For context, eight times a year the Federal Reserve meets to decide whether to raise, hold, or reduce interest rates. Going into Wednesday's meeting, markets didn't know whether the Fed was going to keep rates steady or raise them to combat inflation, which is still running a fair bit above the Fed's 2% target. In the end, the Fed decided to hold rates.
Now, this in and of itself wouldn't have necessarily spooked the markets. Even if headline inflation is above target, there are actually good reasons not to cut rates, including the fact that core inflation, which strips out volatile items like food and energy and is the Fed's preferred measure of inflation, isn't miles above 2% and has been coming down pretty steadily.
What actually spooked the markets, however, were the comments by the new chair of the Federal Reserve, Kevin Warsh. For context, Warsh was appointed by Trump as a successor to Jerome Powell, the previous chairman of the Federal Reserve, who did an impressive job of standing up to Trump when he was trying to pressure the Fed into cutting interest rates, despite the fact that inflation had stayed above the Fed's 2% target for the entirety of Trump's term. There was some anxiety that whomever Trump picks as Powell's successor would not basically bowing to Trump's pressure, cutting rates, and thus stoking inflation.
Warsh was one of the less crazy names on Trump's short list and originally did a pretty good job of convincing the markets that he would, like Powell, be able to stand up to Trump and raise interest rates if necessary. But in his comments on Wednesday, Warsh didn't impress. We're not going to go into too much detail, but the TLDR is that Warsh basically implied that he wasn't worried about inflation because he thought the market would take care of things by itself. This wasn't what the markets wanted to hear because well, they are worried about inflation and they wanted Warsh to instead signal that he was ready to raise rates in the future.
Walsh wasn't helped by the fact that barely an hour later, Trump told reporters in the Oval Office, "Quote, I know Walsh would love to see lower interest rates." Which, unsurprisingly, revived anxieties about Walsh essentially being a Trump stooge.
As well as reflecting an erosion of confidence in America's public finances, this sell-off is additionally bad because it would increase the cost of debt servicing. In other words, paying off the interest outstanding debt. Debt servicing already accounts for about 15% of federal spending, or about 3% of GDP, one of the highest figures in the world. If this ticks up further, there's a risk of the US getting caught in a vicious spiral, whereby higher borrowing costs push up servicing costs, which requires more debt, which pushes up borrowing costs, etc.
Ultimately, there was a whiff of inevitability to all of this, and Trump's revealed disdain for the principle of central bank independence, in other words, the idea that the Fed should be able to decide interest rates without political interference, was always somewhat risky, especially when both inflation and government borrowing were running hot.
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