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The Fiscal Problem Is Not Going Away.
The U.S. fiscal deficit is now running at more than 6% of GDP, and we are approaching a new fiscal year with a massive financing requirement.
Washington is running a deficit of $2T, and the Treasury will continue issuing enormous amounts of new debt to finance that spending and refinance existing obligations.
This matters because deficits are not just a Washington problem. They are increasingly becoming a bond-market problem.
Massive government spending supports demand at a time when inflation remains above the Fed's 2% target. That can make the Fed's job more difficult: fiscal policy is pushing demand higher while monetary policy is trying to restrain it.
And there is another consequence too: Supply, a deluge of debt.
Investors will demand compensation for absorbing that supply, particularly when inflation remains elevated and the Fed is no longer providing the same support to the long end of the curve via QE.
The 10-yr UST move above 5%, levels not seen since 2007 is costly as you see in the chart below.
Higher Treasury yields mean higher borrowing costs for the government, corporations and consumers.
They also raise the discount rate applied to equities, reducing the present value of future cash flows.
This creates a difficult feedback loop: more spending requires more borrowing, more borrowing requires more Treasury issuance, and more supply can require higher yields.
Higher yields then increase the government's interest expense, creating even more pressure on the deficit.
Where has fiscal discipline gone?
For credit investors, there is a silver lining: higher base rates mean higher income for lenders and savers.
In a higher-for-longer world, the winners will be lenders who focus on companies with strong cash flow, conservative leverage, solid covenants and the ability to grow through the cycle.
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