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Bond Investors Worry About Tax Overhaul's Long-Term Cost -- Update

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02/13/2018 | 07:17pm CEST
By Daniel Kruger and Michael S. Derby 

Bond investors are grappling with concerns that the U.S. government's decisions to cut taxes and increase spending are stoking an economy that doesn't need it, at the expense of long-term financial health.

Selling in government bonds that began after the passage of tax cuts and accelerated amid fears of a pickup in inflation has darkened investors' outlook in recent weeks. Even as the government boosts its borrowing, the Federal Reserve has stepped away from bond purchases and is now shrinking its holdings, raising worries about the appetite from private investors who will need to make up the difference.

Because the 10-year Treasury note is a bedrock of global financial markets, rising yields -- which climb as bond prices fall -- can lift borrowing costs, affecting everything from state and local governments to mortgages, credit cards, and corporate loans. Rising yields also can spook stock investors, reducing the appeal of riskier assets relative to Treasurys.

After years of central bank support for markets helped cap volatility, investors are becoming increasingly worried that the Fed's decision to step back from crisis-era policies is pulling cash from the economy at a time when many financial assets are perceived as relatively overvalued.

The new course of U.S. spending comes at a time when the bond market is wrestling with a significant shift in global economic performance, with improving growth in the U.S. and elsewhere broadly credited for propelling an increase in real yields, which measure the purchasing power of bonds' fixed payments after accounting for inflation.

The upswing in inflation expectations reflects investors' concerns about everything from the effect of U.S. expansion to rising commodities prices. Investors will get a new view of inflation -- which threatens the value of government bonds because it erodes that purchasing power -- from Wednesday's release of the consumer-price index.

The crosscurrents of rising government bond yields and increased volatility in other assets last week contributed to the largest weekly percentage decline for the Dow Jones Industrial Average in two years, underscoring the importance of the bond market's reaction to a surge of fiscal stimulus and borrowing that comes after eight years of slow but steady economic expansion.

"There's this 'cross your fingers and hope we grow enough to deal with this' approach, which is disturbing to me," said Jerry Paul, a bond fund manager at ICON Advisers.

U.S. government bond yields have risen to multiyear highs since Congress passed the tax cuts, which economists and investors have said will modestly accelerate growth, potentially leading employers to raise wages and increase capital investment. To fund it, the government began increasing the amount of bonds it will sell, and analysts expect it will announce additional increases in May. Analysts say new budget plans and a possible increase in infrastructure spending could also boost issuance.

Moody's Investors Service said in a report Friday that "the federal government's balance sheet is set to deteriorate materially" as mandated spending on Social Security, Medicare and debt service, along with a jump in military spending and a decline in tax revenue, weakens the U.S. fiscal outlook.

Concerns about inflation have also contributed to the selling in government debt. Signs of accelerating wage growth in January helped push a market-based measure of inflation expectations to an average of 2.14% through 2028, the highest since September 2014, according to Thomson Reuters data. That so-called break-even rate reflects the difference in yield between the 10-year Treasury note and its inflation-protected counterpart. A wider gap attracts investors seeking protection from rising consumer prices.

Even as inflation expectations have since eased and the cumulative additional debt sales totaled only $4 billion in the first series of auctions at new, higher amounts, the impact on investors' perception of where bond yields are headed has been significant, several analysts said.

Fed officials don't seem to be all that worried by the recent rise in yields, but they are becoming increasingly anxious about the longer-run outlook for the market and the cost of credit in the U.S. economy.

Key Fed officials view the recent uptick in government borrowing costs in a somewhat positive light, saying the bond market shift appears to reflect investors finally coming to terms with the fact that major central banks' crisis-era easy-money policies are coming to an end. But they worry there is a bigger storm looming.

Although they usually refrain from offering opinions about government spending, Fed officials have long warned that a surge in social-welfare spending -- as baby boomers retire in an economy with a smaller labor force and already large deficits -- is unsustainable.

What's more, the Fed's plan to continue raising its short-term interest rate target, at a time when other central banks are likely to be moving in the same direction, will make it more expensive for the government to pay the interest on all the money it is borrowing. For a number of Fed officials, the risk is that an already unfavorable outlook for government borrowing becomes even worse, having a major negative impact on the economy.

"There is no such thing as a free lunch," Federal Reserve Bank of New York President William Dudley said in mid-January, after the tax bill's passage but before the market's recent turmoil. The tax law "will increase the nation's longer-term fiscal burden, which is already facing other pressures, such as higher debt service costs and entitlement spending as the baby-boom generation retires." Those dynamics could drive up interest rates and crowd out private-sector investment, hurting the economy and counteracting the favorable impact of tax cuts, he said.

Mr. Dudley's counterpart at the Federal Reserve Bank of Dallas, Robert Kaplan, said Thursday in Frankfurt that the government should now be lowering its borrowing relative to the economy's size, rather than digging a deeper hole.

For the immediate future, rising bond yields aren't that big of an issue for central bankers. In a Bloomberg TV appearance last week, Mr. Dudley tied declines in share prices to the shift in the bond market and called stock losses "small potatoes." He also said that bond yields had been unusually low given the solid economic outlook and the future path of central bank interest-rate policy.

Some investors, however, remain concerned.

"This is a serious issue, and it's going to get much more difficult," said Gene Tannuzzo, a bond manager at Columbia Threadneedle Investments. Should the trend continue it may, lead yields to "get higher and higher, and it starts to pinch the economy."

Write to Daniel Kruger at Daniel.Kruger@wsj.com and Michael S. Derby at michael.derby@wsj.com

Stocks mentioned in the article
ChangeLast1st jan.
DJ INDUSTRIAL 0.70% 26429.13 Delayed Quote.6.18%
NASDAQ 100 -0.50% 7456.4239 Delayed Quote.17.17%
NASDAQ COMP. -0.42% 7922.221 Delayed Quote.15.25%
S&P 500 0.54% 2904.31 Real-time Quote.8.05%
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