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As Scott Bessent, Trump’s Treasury secretary nominee, endured his first Congressional hearing on Thursday, he was grilled about America’s economic challenges.
Even before he started, however, evidence had emerged of these: on Wednesday the Mortgage Bankers Association reported that the 30-year mortgage rate had jumped above 7 per cent, following a 1 percentage point rise in 10-year Treasury yields since last autumn.
This is not particularly punitive by the standards of financial history. Since 1971, the average mortgage rate has been 7.73 per cent — and before 1990, rates generally sat over 10 per cent. But the rub is that US voters have become used to rates of 3 per cent in the past decade. Indeed the real estate industry has became so addicted to cheap money that insiders tell me that if 10-year yields rise to 5 per cent for any period of time — from the current 4.65 per cent level — they expect strings of defaults.
And what is particularly notable — and unwelcome — about this development is that it has occurred even though the Federal Reserve has loosened policy quite markedly since last autumn. Such divergence is highly unusual — and implies that traders are blowing a big fat raspberry at the Fed.
Why? If you are an optimist, you might blame the strong US growth outlook for rising rates. A less upbeat explanation is that investors are braced for price rises. For while equity markets rallied this week on better than expected inflation data, this could change if president-elect Donald Trump follows through on his threats to introduce trade tariffs and mass deportations.
Another possible explanation, suggests the Centre for Economic Policy Research, is that non-US central banks are furtively cutting their Treasury purchases. And one factor that could be pushing long-term yields up is that Bessent has (rightly) criticised Janet Yellen, his predecessor, for expanding short-term debt issuance. This implies he hopes to sell more long-term debt.
However the most contentious — and consequential — issue is the US fiscal outlook. Rightwing pundits have warned for years that this is on an unsustainable track: on current trends, the debt-to-GDP ratio is projected to move from 100 per cent to 200 per cent in a decade — and the deficit is now running at over 6 per cent of GDP.
That sparked Luke Gromen’s influential “Tree Rings” newsletter to warn that if the 10-year yield rises above the nominal growth rate it is “mathematically certain to quickly trigger a debt death spiral . . . unless either or both US rates are cut quickly or US nominal growth is accelerated higher”. He believes this may have already occurred.
More notable still, this week Ray Dalio, the founder of Bridgewater hedge fund, published the first part of his analysis of historical debt crises. He said he was “deeply concerned” that America will “go broke” and warns that a multi-decade debt cycle could soon implode.
Thankfully, Dalio thinks this ugly scenario could still be avoided if radical reforms make the debt burden more sustainable. This could include cutting interest rates to 1 per cent, letting inflation rise to 4.5 per cent, increasing tax revenue by 11 per cent, slashing discretionary spending by 47 per cent or some combination.
But implementing such a holistic policy mix will be tough, he added. And that has two implications. In macroeconomic terms, it constrains Bessent’s room for manoeuvre; he admitted on Thursday that the country was now “hard-pressed” for fiscal firepower. And in financial terms, there is a notable — and rising — risk of market turmoil if investors embrace Dalio’s dark predictions.
I am told that some of Trump’s supporters, such as Howard Lutnick, head of Cantor Fitzgerald and the nominee for commerce secretary, insist that such market pressures can be contained. After all, global financial institutions need to buy and own Treasuries — almost irrespective of price — to meet regulatory rules. And foreign investor demand for US debt still seems sky high, particularly in places such as Japan.
But, as I have noted before, a swelling part of this foreign demand is now coming from potentially flighty hedge funds. And during a recent trip to Asia, senior financiers muttered that they are furtively hunting for ways to hedge their vast Treasuries exposures — even as they gobble them up. The same thing is happening in Europe.
Thankfully, Bessent seems to understand these dynamics well. Indeed, he told Congress that the reason he left his “quiet life” as a hedge fund manager to serve in Treasury was because he feels a duty to tackle these fiscal pressures — and thus avoid Dalio’s doom loop.
But whether he has the political power — or savvy — to do this is anyone’s guess. He is certainly in a race against time. So investors had better keep watching those Treasury yields.
After all, one thing that Trump does not want on his watch is a full-blown market meltdown, let alone a Maga revolt over surging mortgage rates. If anything is going to impose discipline on his administration, it might just be those bond rates; indeed, it is probably the only factor that will.
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