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The Upcoming Crossroads of Fiscal and Monetary Policy  

Andrew Foran, Economist | 416-350-8927 

Date Published: November 24, 2022

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Highlights

  • The Federal Reserve has significantly increased interest rates, which will impact the federal government’s sizeable debt refinancing plans over the coming years. This presents a few risks for volatility in the Treasury market and on fiscal plans. 
  • Some of the dislocations recently suffered in the Treasury market could worsen because of increased refinancing needs. In addition, elevated refinancing needs next year could intersect with Congressional wrangling over talks to raise the debt ceiling, potentially adding to the volatility.
  • The budgetary implications of increased debt servicing costs could lead to increased fiscal restraint in the coming years, which may weigh on economic growth.

Working in unison with the Federal Reserve at the onset of the pandemic, the U.S. Treasury delivered extraordinary stimulus via government spending. This fiscal support was debt-financed at rock-bottom interest rates. Almost three years later, the bill is coming due and interest rates are a lot higher. Over the course of the next two years (2023-2024), thirty percent of all outstanding marketable Treasuries will mature, over half of which was issued at rates 2-3 percentage-points (ppts) below those prevailing in the market. In total, there is over six trillion dollars of debt which will mature over the next two years.

Pandemic Market Dynamics Shortened the Duration of U.S. Debt

Chart 1: The distribution of total outstanding marketable U.S. Treasuries by original issuance maturity has changed since 2019. Less bills were issued, with issuance shifting into two- and three-year Treasury notes. Five-, seven-, and ten-year notes also saw their share of outstanding Treasuries decrease since 2019. In addition, the revival of the twenty-year bond decreased the outstanding share held by thirty-year bonds. For other Treasuries, inflation protected securities saw their share decrease while the share of floating rate notes stayed relatively the same.

In response to market conditions, financing the massive pandemic spending in the CARES Act and other government measures was disproportionately carried out at the shorter end of the yield curve – primarily at two- and three-year terms (Chart 1). The 2 to 3-year range cumulatively increased its compositional share by roughly three percentage points. Some of this was shifted from short term bills (i.e., 6-month bill), and some came from longer-term Treasuries such as the 5- and 7-year notes. The second shift came with the revival of the 20-year bond, which was last issued in 1986. It’s share of outstanding marketable Treasuries is very modest (roughly 3%), but its relative share increase pulled down the compositional share of the 10-year note and to a lesser extent the 30-year bond.

It likely seems counter-intuitive to swap longer-term securities for shorter-term securities in a low-rate environment, but the U.S. Treasury Department must line-up its issuance with market dynamics. Given the Fed’s purchases – as part of its quantitative easing program – were disproportionately at the short end of the curve, a large-scale shift into longer-term notes and bonds would have dried up market liquidity for shorter-term maturities, exacerbating the already precarious position of financial markets at the time.

Even so, on aggregate we still saw a decline in the average yield and an increase in the average maturity for outstanding marketable Treasuries relative to before the pandemic (Table 1). The average yield at issuance dropped by almost half a percent to 2.1%, while the average maturity at issuance ticked up to more than 14 years. The extension of the average time to maturity and the lower average issuance yield should be a mitigating factor to the refinancing risk faced by the U.S. over the long-term.

Table 1: Average Yields Down and Maturities Up

Note: Includes U.S. Bills, Notes, Bonds, & TIPS. Source: U.S. Treasury, TD Economics.
  2019 2022
Average Issuance Yield,  % 2.5 2.1
Average Maturity, Years 13.7 14.2

Refinancing Could Add to Treasury Volatility

When U.S. Treasuries mature, the government must pay back the initial principal. Of the debt issued to finance the government’s pandemic spending surge, it is that which was issued in two- and three-year maturities which will be the most consequential in 2023 and 2024.

Chart 2: The value of maturing U.S. Treasury notes has risen every year since the pandemic began. 2023 and 2024 will see the total value of maturing notes hit $2.5 trillion, driven mostly by a jump in maturing two- and three-year notes. This is roughly $1 trillion higher than the value of maturing Treasury notes in 2018. Chart 3: The U.S. Treasury notes which will mature in 2023 and 2024 will face higher financing costs than when they were originally issued. Two- and three-year notes will see the largest increase in yields as they were issued during the low-interest rate period earlier in the pandemic. Longer term notes (five-, seven-, and ten-years) will see smaller though still positive changes in yields, as yields are forecast to remain above pre-pandemic levels when they were originally issued.

The impact of pandemic debt issuance can clearly be seen by the fact that the value of maturing Treasury notes is roughly $1 trillion higher in 2023/2024 relative to five years ago (Chart 2). These Treasuries will need to be refinanced at much higher rates, particularly at the short end of the yield curve (Chart 3). The two-year note will see less of an impact in 2024 as these securities were issued at higher rates. The three-year note will see a more consistent yield increase in both 2023 and 2024 because the securities maturing in the next two years were issued in 2020 and 2021. Still, the 2024 yield difference will be less as we anticipate that yields will fall throughout 2023 and into 2024 with the Fed switching to a more accommodative stance amid a slowdown in economic growth. Yield differences relative to the time of issuance remain positive across most of the curve as interest rates are expected to stay above their pre-pandemic levels. The longer-term notes that will mature in the coming two years were issued before the pandemic, and therefore reflect smaller relative yield differences.

There are two risks related to this wave of refinancing. First, since the Fed began quantitative tightening, the Treasury market has suffered some dislocations (see Question 3 in Q&A). Thus, this higher refinancing need could cause more challenges on this front. Second, given this will be occurring at the same time as a potential debate about raising the country’s debt ceiling, there are significant odds of heightened volatility.

Chart 4: The three-month moving average of month-over-month changes in Federal Reserve Treasury holdings began to turn negative in June as the Fed began quantitative tightening. Interestingly, the same measure of foreign Treasury holdings turned positive in July and moved inversely to the Fed's Treasury roll-off, indicating that foreign entities may be picking up where the Fed left off.

After the Fed began allowing the Treasuries on its balance sheet to roll-off (mature without reinvesting the proceeds), market liquidity and depth have been partially impaired as the largest buyer is no longer buying. While the Fed is no longer an active buyer, it appears that foreign buyers momentarily picked up the torch in July and August (Chart 4). Domestic investors have also increased their holdings of Treasuries in recent quarters, likely drawn in by higher yields. Demand for Treasuries is expected to hold up as yields in the U.S. remain relatively rich compared to other advanced economies, and recession fears keep demand for this safe have asset healthy.

Related to the second risk, estimates suggest the federal debt ceiling will need to be raised in the first half of 2023. Just after the new divided Congress is sworn in in January. It is possible that Congressional Republicans will use the debt ceiling deadline as leverage to impose more spending restraint or achieve other policy goals. We don’t expect a repeat of the 2011 debacle when the last-minute brinksmanship resulted in a U.S. downgrade, but there is the potential for volatility. The U.S. Treasury Department can undertake “extraordinary measures” as they get close to the limit, but it is most likely that an agreement will be reached and the debt ceiling will be raised without incident. However, coupled with QT, drawn-out negotiations could present further volatility risks in Treasury markets.

Fiscal Restraint is Coming

The political wrangling is highly uncertain at this stage, but higher debt financing costs will have a notable impact on the federal budget. In the near-term, higher debt service payments will require either diverting funds from other sources (i.e., cutting spending), raising revenue (i.e., raising taxes), or issuing larger amounts of debt. In 2021, federal net interest payments were $352 billion, and the CBO estimates that will rise to around $450 billion in 2023 – roughly $130 billion higher than it estimated a year earlier. That difference grows to around $200 bn in 2023. As a share of GDP, the CBO has forecast that federal net interest outlays will nearly double by the end of the decade (Chart 5).

However, the CBO forecasts were last updated in May, at a time when the projected terminal rate for the Federal Reserve was roughly 1.5-2% lower than present forecasts. Our current expectations are for net interest outlays (as a % of GDP) to rise slightly quicker in the medium term relative to CBO July estimates and sit near 3.3% by 2030.

Chart 5: Federal net interest outlays (as a % of GDP) peaked in the 1980s before declining in the 1990s and leveling off in the 2000s. In July 2022, the Congressional Budget Office (CBO) forecast that net interest outlays will rise noticeably over the next decade, nearly returning to the 1980s peak by 2030. Based on renewed guidance surrounding monetary policy since July, TD expects that net interest outlays will rise more quickly in the near-to-medium term, reaching roughly 3.3% of GDP by 2030. Chart 6: Outside of a four-year period in 1998-2001, the U.S. has run budget deficits since 1970. The Great Financial Crisis in 2008 and the Covid-19 pandemic in 2020 resulted in very large and multi-year deficits. After 2008, federal deficits rose in the run-up to 2020, and looking forward the CBO projects that deficits will rise considerably over the course of the next decade.
For the past fifty years, outside of a brief four-year period in 1998-2001, the U.S. has run budget deficits. These deficits were already trending higher prior to the pandemic (Chart 6). While the crisis-era swelling in the budget has already improved, the accumulated debt load, combined with higher interest rates and growing entitlement spending as the population ages all play a role in driving net interest costs higher over the forecast horizon.
 
These risks are not unique to the U.S. and are long-term in nature. Congress could opt to kick the can down the road on their structural deficit as they have in recent years, enabled by the critical role that Treasuries play in the international financial system. But, higher interest rates have increased the cost of doing so. Also, there is historical precedent for a Republican controlled House to push for greater spending restraint when a Democrat is President. How much restraint we will see is highly uncertain, but even to keep the deficit steady as a share of GDP will require notable restraint given higher interest costs. If Congress wants to shrink the deficit, the restraint will need to be much higher and will be a drag on economic growth.

Bottom Line

The federal government issued a sizeable amount of debt during the pandemic, with much of it issued in two- and three-year Treasury notes. Thirty percent of outstanding Treasuries will mature over the next two years and will need to be refinanced at higher interest rates in a Treasury market that has been having some liquidity challenges recently. Added to that is the need to raise the debt ceiling in the first half of next year with Congress divided. If there is last minute drama between Republicans and Democrats in coming to an agreement, volatility could also increase. Looking past short-term volatility, it is likely that higher borrowing costs will raise the amount of fiscal restraint that is coming down the pipe over the next couple of years.

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