Last week’s sharp move higher in US bond yields was indicative of the risks that are developing in markets. They prompted a cascade of commentary on ‘Treasury basis trades’, ‘swap spread trades’, etc. These explanations are appealing for several reasons, but most importantly, they frame the rise in bond yields as a temporary market disruption that has a technical fix. However, the focus on ‘dislocations’ in the Treasury market sidesteps the crucial issue: the deteriorating fiscal position of the US. A day after Trump’s tariff U-turn, the House has adopted the Senate’s amended version of the budget resolution, which allows for $5.3tr in deficit-financed tax cuts, deficit increases of $521bn on defence and immigration spending, and an increase in the debt limit of up to $5tr.
Scott Bessent’s concerns surrounding the US fiscal position are legitimate. But there are deep, underlying contradictions in the stated aims of the current US administration. The deficit has continued to widen fiscal year-to-date. Alongside the unprecedented tax cuts in the pipeline, the spending cuts made to the IRS and climate programmes threaten to put the public finances on an even more precarious footing. DOGE has sharply now revised down its expected savings for this fiscal year. Where there has been clear evidence of fraud (according to a yearlong investigation of Medicare Advantage by the WSJ), the Trump administration has turned a blind eye.
Investors should demand a premium for holding US government debt, given the backdrop of persistently large federal budget deficits, growing fiscal risks, and attempts to push the dollar lower and reorder the global trading system. Inflation risks and policy uncertainty should also raise the term premium.
Any serious risk management strategy for the US Treasury, cannot ignore the implications of climate change. This is a clear blind spot for the current US administration. By doubling down on fossil fuels, the US is increasingly exposed to climate transition risks. By hamstringing their own renewables sector, the US will become less competitive vis-à-vis China over the longer-run. The eventual transition to clean energy will degrade US economic and security interests while advancing China’s. China has now suspended exports of a wide range of critical minerals and magnets, threatening to choke off supplies for key sectors, including autos, aerospace, semiconductors, and defence.
