Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Watches the Budget Deficit
Transcript
- Lucas: So the ten-year Treasury yield just touched four point seven two percent, and the yield curve is steepening while the Fed sits on hold. In a normal world, cooling inflation should be pulling long-term yields down, not pushing them up. Something else is moving the bond market now, and I think it's the budget deficit. Luna: The deficit again? We've talked about the Fed ignoring it, but you're saying bond investors are now pricing it in directly. Lucas: Exactly. Look at the July data. The deficit surged to its highest level since March 2021. And the ten-year yield has climbed about nine basis points over the past week alone, while the two-year is actually down slightly. That's a steeper curve, and it's not because inflation expectations are spiking — the ten-year breakeven is only two point two seven percent. Luna: So the real driver isn't inflation, it's the supply of Treasuries flooding the market. Lucas: Right. The government is borrowing heavily to fund a deficit that's running at about six percent of GDP. But GDP itself is growing at only one point five percent annualized. So the debt is growing faster than the economy, and that creates a supply-demand imbalance in the bond market. Investors are demanding a premium to hold all that new paper. Luna: And that premium is what we call the term premium, right? The extra yield for taking on longer-term risk. Lucas: Yes. And we can see it in the five-year and ten-year yields. The five-year is at four point three eight, the ten-year at four point seven two. That's a spread of about thirty-four basis points. Normally, you'd expect that to be narrower if the Fed is about to cut rates. Luna: But the Fed is on hold, and the effective fed funds rate is stuck at three point six three. So the market is saying: short rates stay put, but long rates rise because of fiscal risk. Lucas: And that's the paradox. Inflation is cooling — core PCE is at two point three percent annualized, right in line with the Fed's target. So the Fed has every reason to cut. But they can't, because the bond market is effectively doing the tightening for them. Higher long-term yields raise borrowing costs for everyone. Luna: So the Fed is stuck between its inflation mandate and fiscal reality. Lucas: Precisely. And what's interesting is that the Fed doesn't directly control long-term rates. They set the short-term policy rate, but the ten-year is set by the market. So when the market decides that the deficit is unsustainable, it demands a higher yield to compensate for the risk of future inflation or default. Luna: And that risk premium is now a bigger factor than inflation expectations themselves. Lucas: That's the key insight. The ten-year breakeven inflation is only two point two seven percent, which is actually below the two-year breakeven. So the market doesn't expect inflation to be a long-term problem. But the ten-year nominal yield is still high. The difference is the term premium, and that's driven by supply. Luna: So it's like the market is saying, 'We don't think inflation will be a problem, but we're not sure the government will pay us back.' Lucas: Not exactly default risk, but inflation risk and the risk that the Fed will have to monetize the debt at some point. That's why we see the curve steepening despite the Fed's pause. And this has real consequences for the economy. Luna: Like higher mortgage rates, for example. The thirty-year fixed is already above six and a half percent, and that's going to keep housing in the dumps. Lucas: And that feeds into the GDP numbers. We saw real GDP growth slow to one point five percent annualized in the second quarter, down from two point one percent. A big part of that is the drag from higher long-term rates. So the deficit is not just a fiscal problem; it's becoming a monetary transmission problem. Luna: It's like the bond market is doing the Fed's job for them, but in a way that might cause more economic damage than a targeted rate hike would. Lucas: Exactly. And that's why the Fed is in such a tough spot. If they cut rates to stimulate the economy, they risk fueling inflation expectations. But if they hold, they're letting the bond market tighten financial conditions for them. Either way, they're damned if they do, damned if they don't. Luna: And meanwhile, the deficit keeps growing. The budget deficit in July was the highest since March 2021, and there's no sign of fiscal consolidation. Lucas: Right. And that's the thing we keep coming back to. The Fed can't solve the deficit. Only Congress and the administration can. But the Fed has to deal with the consequences. So when we talk about the Fed's next move, we have to ask: what will the bond market do? And that's exactly why we're watching the ten-year yield so closely. Luna: So you're saying that the Fed's decision in September might be less about the data and more about the yield curve. Lucas: Partly. But they'll also be looking at the jobs report, which showed unemployment dipping to four point one percent, and payrolls down slightly. That's a mixed picture. But the bond market signal is hard to ignore. If the ten-year keeps climbing, the Fed might have to acknowledge that fiscal policy is undoing their monetary stance. Luna: And that would be a big deal — the Fed openly commenting on fiscal policy. Lucas: It's a fine line. They usually avoid that. But sometimes they can't help it. Remember in the past, when the Fed chair would say that the debt trajectory is unsustainable? We might hear more of that if this continues. Luna: Speaking of the bond market and the deficit — we've been talking about how the Fed can't control long-term rates. But there's something else that's interesting: the term premium has been negative for years, and now it's turning positive. That's a shift that has big implications for investors. Lucas: Yeah, that's a great point. For a long time, investors were willing to accept negative term premium because they expected low inflation and a sluggish economy. Now, with the deficit exploding, they're demanding a premium to hold long-term debt. That's a structural change, not just a cyclical one. Luna: And that affects everything from pension funds to mortgage rates to corporate borrowing costs. Lucas: Absolutely. And it's one more reason why this episode matters. We're not just talking about a small blip in the bond market. This is a generational shift in how investors view U.S. government debt. And it's happening while the Fed is trying to navigate a soft landing. That's a tough combination. Luna: So what should our listeners take away from this? Besides the obvious 'deficits matter' lesson. Lucas: I think it's that the bond market is now a key constraint on the Fed. And if you're an investor, you need to pay attention to the supply of Treasuries and the term premium, not just the Fed's dot plot. Luna: So it's a fiscal story, not just a monetary one. Lucas: Exactly. And the irony is that the Fed is trying to fight inflation that's actually pretty close to target, but they're being forced to keep rates higher because the bond market is worried about the deficit. That's a policy trap that doesn't have an easy exit. Luna: And before we wrap up, I want to say something about this episode itself. If walking through the economy with us has made something click for you, we've deliberately kept this show free of ads. It's just us, talking through the numbers. If you'd like to support that choice, there's a link in the show notes at buy me a coffee dot com slash fexingo. Lucas: That's right. No ads means we can go deep without interruptions. It's listener support that keeps it that way. And we appreciate anyone who chips in. Luna: So back to the yield curve. What do you think breaks first: the Fed or the bond market? Lucas: That's the million-dollar question. My guess is the bond market will keep pushing yields higher until something gives. Either the economy slows enough that the Fed has to cut, or the deficit gets addressed. But I don't see either happening soon. So we might be in for a prolonged period of higher long-term rates. Luna: And that has implications for the dollar, for emerging markets, for everything. Lucas: Absolutely. And it's a story we'll be following closely. Thanks for joining us on this deep dive, and we'll be back tomorrow with more.