As a new capital markets associate at Lehman Brothers in 2001, I was thrown into the summer program mating ritual known as rotations. That’s when you spend time working in various areas of an investment bank before being assigned to a department. The least popular assignment at the time was the government bond trading desk. Why? Because the U.S. was running a budget surplus, and everyone knew there would be no more government bonds to trade because the government’s borrowing needs would drop if there was no deficit to fund.
As we know, government bond trading survived. Fiscal discipline went out the window after the Sept. 11. attacks and people were no longer squeamish about spending money if it was for counter-terrorism purposes. A whole new government agency — the Department of Homeland Security — was created out of thin air. And there went the surpluses.
We have a much different problem today: too many bonds. It looks like trillion-dollar deficits are going to be a staple of the U.S. economy for the foreseeable future. Very few people outside of Wall Street understand the implications. Very few politicians understand, either. If you spend any time studying the entrails of a government bond auction, it is easy to see how the supply of bonds can overwhelm the demand, resulting in lower prices and higher interest rates. And that’s not just for the government, but for companies and consumers as well.
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Nobody has spent much time thinking about this, because following the financial crisis the Federal Reserve was buying government bonds by the bucket load and everyone wanted — or needed, because of new regulations — safe assets. But now, things are changing. China and Japan seem to be staging a buyer’s strike, and there isn’t much domestic demand because people are preoccupied with stocks and stuff such as Bitcoin. That’s a not-so-fancy way of saying risk preferences have changed.
We should care very deeply about interest rates, but we don’t. That’s probably because rates have been low for so long that the deficit hawks and bond vigilantes have fallen asleep. Nobody in politics today is really capable of speaking articulately on the need for less public borrowing. It has been a long time since anyone has uttered the phrase “crowding out,” but that is essentially what happens when the government runs large deficits: Public borrowing crowds out private borrowing, and rates rise for everyone because there’s only so much money to go around.
If 10-year Treasury note yields go from 2% to 3%, and mortgage rates go from 3.75% to 4.75%, there will be a class of homebuyers who can’t make the math on the monthly payments work. That family will be denied homeownership because the government wanted more aircraft carriers or more food stamps or something else. Most economists probably think households are better at deciding what to spend money on than the government, so the economy will suffer in a roundabout way.