Latest / The National Debt Podcast with Fexingo: Treasury, Borrowing, and Long-Term Fiscal Outlook / How The Deficit Is Eating Treasury Yields
Transcript
- Lucas: Look, the headline number from Friday was brutal. The US budget deficit swelled to almost two trillion dollars for fiscal twenty twenty six, up twelve percent in a single year. That is not just a gap; that is a structural hole that keeps widening every time the government opens its checkbook. Luna: It feels like we are watching the math fail in real time. Twelve percent growth in the deficit when the economy isn't growing at twelve percent? That mismatch has to be driving something in the bond market. Lucas: Exactly. And here is where it gets weirdly counterintuitive for anyone who has been watching the ten-year yield. Despite that massive new supply of debt, the ten-year Treasury yield actually ticked down to five point zero nine percent as of mid-October. Usually, you would expect that much new borrowing to push yields higher because there are more bonds chasing the same pool of buyers. Luna: So if demand isn't drying up, what is keeping those long-term rates from spiking? Is the Fed stepping in to absorb some of that load? Lucas: Not directly absorbing it, but the market is pricing in a very specific scenario. The Fed Funds effective rate is sitting at three point seven five percent, and the daily rate is holding steady at three point eight eight percent. Investors are betting that the central bank will hold rates here or cut slightly, which anchors the front end of the curve. But the ten-year is still hovering around five percent, which suggests they think the deficit itself won't force the Fed to keep rates high forever. Luna: That seems risky. If the deficit keeps growing by twelve percent a year, doesn't that eventually force inflation back up, regardless of what the Fed does today? Lucas: That is the exact fear. We have the federal debt to GDP ratio sitting at one hundred twenty-two point six percent as of the start of this year. It is creeping up, and with the total federal debt hitting nearly thirty-nine point four trillion dollars, the interest expense alone is becoming a line item that compet with defense and social security. You cannot print your way out of that without devaluing the currency. Luna: But right now, the spread between the two-year and the ten-year is only thirty-eight basis points. That curve is barely steepening. Isn't that a sign that investors aren't actually worried about the long term yet? Lucas: I would argue they are worried, but they are confused. A thirty-eight basis point spread tells me the market thinks the Fed will eventually win the inflation fight, even while the Treasury is flooding the system with cash. It is a strange disconnect. We saw PPI come in hot last week, which reminded everyone that price pressures are sticky. Yet, the bond market is acting like it trusts the Fed's timeline over the Treasury's spending habits. Luna: Do you think that trust is going to snap soon? Or is the sheer size of the US economy just too big to fail in this context? Lucas: The size helps, sure. But let's look at the auction dynamics. When you issue that much debt, you need buyers. Right now, foreign holders are getting cautious, and domestic banks are capital constrained. That leaves the Federal Reserve and wealthy institutional investors as the marginal buyers. If they get tired, yields go up, and the interest cost on that thirty-nine trillion dollar pile becomes unsustainable. Luna: So it is less about the total debt number and more about who is willing to buy the new issuance every month. That sounds fragile. Lucas: It is extremely fragile. And here is the thing most people miss. The thirty-year yield is sitting at five point four three percent, which is flat lately. That stability is masking the volatility underneath. If you look at the short end, the three-month Treasury yield dropped to four point two six percent. The market is pricing in a soft landing, but the deficit data says hard landing. Luna: If the deficit keeps growing at that twelve percent clip, do we see a repricing event where yields suddenly jump to compensate for the risk? Lucas: We might already be seeing the early stages of it. Remember, the interest on reserve balances is at three point nine zero percent. The government is paying that rate to banks for their reserves. As the debt grows, that interest payment bill explodes. It becomes a self-fulfilling prophecy where higher debt leads to higher interest payments, which requires even more debt to service the old interest. Luna: That is a vicious cycle. It feels like we are ignoring the compounding effect until it hits all at once. Lucas: We always ignore compounding until it hurts. But right now, the data shows the ten-year yield is lower than it was last month. So why are we talking about danger? Because the yield drop is tiny. It is not a crash. It is a slow leak. And the deficit is the hole in the boat. Luna: Okay, so what does this mean for someone listening who has retirement savings tied to bonds or stocks? Do they need to hedge against this fiscal mess? Lucas: They need to understand that fixed income is no longer a safe haven. It is a liability. With the ten-year at five percent, you are getting paid to take duration risk, but that risk is rising. I think the smart move is to look at shorter durations or assets that can survive inflation, not just assets that promise a fixed return. Luna: Shorter durations make sense. You avoid being stuck in a five percent bond when inflation spikes again and forces the Fed to hike rates back up. Lucas: Precisely. And remember, the VIX is sensitive to these fiscal shocks. If the Treasury has to issue debt at a higher yield because buyers flee, the stock market reacts. It is not just a bond story anymore. It is a whole-market story. Luna: Right. The correlation between fiscal health and equity valuations is tighter than people admit. Lucas: Let's pause here for a second. If walking through the economy with us has made something click, we want to mention that this show is entirely listener funded. No ads, no sponsors, just us digging into the data. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. — and that is literally what funds making this many of these deep dives possible. Luna: Yeah, it really keeps the lights on and allows us to spend the time necessary to verify these numbers instead of just reading headlines. Lucas: Thanks for supporting the work. Now, back to the deficit. Let's talk about the international perspective. India’s finance minister recently said market liquidity makes it easier for investors to exit. Does that signal a global shift away from US debt? Luna: It signals that other markets are developing depth. Investors have options now. They don't have to park everything in Treasuries if the US fiscal picture looks messy. Lucas: That is a crucial point. For decades, there was no alternative. Now, with emerging markets stabilizing and other developed nations managing their books differently, the US loses its monopoly on safety. If foreign capital slows down, the burden falls entirely on domestic buyers. Luna: And domestic buyers are already stretched. Household debt is high. Banks are wary. Who is left to buy? Lucas: Pension funds and insurance companies. They are mandated to hold long-term assets. So they become the forced buyers. But they are also sensitive to interest rate changes. If yields spike, their liabilities change too. It is a complex web. Luna: So the system is stable only as long as everyone agrees to play by the same rules. One shock could unravel that agreement. Lucas: Agreed. And looking at the labor market, women may be at greater risk of AI job losses according to recent reports. If employment weakens, tax revenues drop. That makes the deficit problem worse, not better. Luna: So it is a double whammy. Higher spending needs and lower revenue potential. The math really doesn't add up. Lucas: It doesn't. Unless we see massive productivity gains from AI that offset the labor loss, the revenue side of the equation is under pressure. We are seeing hot PPI numbers, which means costs are rising. Higher costs for the government mean higher deficits. Luna: It feels like we are running out of time to fix this before the next election cycle puts politics ahead of pragmatism. Lucas: Politics always wins in the short term. But the bond market doesn't care about elections. It cares about numbers. And the numbers are screaming. Luna: So what is the takeaway for the listener? Just watch the ten-year yield? Lucas: Watch the spread. Watch the auction results. And realize that your safe assets are no longer safe. Adapt your portfolio to reflect a world where fiscal discipline is gone. Luna: A world where you have to actively manage risk rather than just hoping for stability. Lucas: Exactly. Stay sharp, stay diversified, and keep an eye on those Treasury auctions. The market is telling us something, we just have to listen.