US Deficit Hits $1.7T, Treasury Yields Rise Amid Fed Policy

Key Takeaway

• US federal budget deficit projected to rise to $1.7 trillion in 2023, driving increased Treasury debt issuance.
• Rising Treasury yields more influenced by Federal Reserve policy expectations than supply concerns.
• Political division may inadvertently lead to smaller deficits due to challenges in passing major fiscal legislation.

Deficit Concerns and Treasury Demand

The US federal budget deficit is projected to increase to $1.7 trillion in 2023, up from $1.375 trillion in 2022, as reported by Goldman Sachs Research. This escalation necessitates the US Treasury to issue more debt to fund the rising deficits. Jonny Fine, head of Global Investment Grade within the Financing Group at Goldman Sachs, highlighted the challenge of finding sufficient demand to absorb the substantial supply of Treasury debt entering the market. Despite these concerns, there has been enough investor demand to keep the market stable for now. The question remains whether yields will need to adjust to attract more investors, as yields have already seen a significant rise this year, primarily influenced by Federal Reserve policy rather than the increased supply of Treasury debt.

Political Climate and Fiscal Legislation

Alec Phillips, Chief US Political Economist at Goldman Sachs, noted the lack of political will to address deficit reduction, attributing it to low voter focus on the issue. The outcome of the presidential election and the control of Congress could significantly impact the deficit. Historically, major fiscal legislation tends to pass when one party controls the House, Senate, and White House, leading to different scenarios for the deficit depending on the political landscape. A divided government might result in a slightly smaller deficit due to existing fiscal restraints, such as expiring tax cuts and spending caps.

Market Reactions and Treasury Auctions

Recent Treasury auctions have shown mixed results, with a notable auction of 10-year notes drawing tepid demand, resulting in a yield of 4.483%, slightly higher than pre-auction trading levels. This followed a rally that reduced 10-year yields by over 20 basis points. Despite these fluctuations, the market has generally absorbed the increased supply of Treasury debt well, with moments of concern about deficit financing and Treasury issuance seen as temporary bumps rather than precursors to a major market correction.

Dollar Strength and Financing Deficits

Former Treasury Secretary Steven Mnuchin commented on the advantage of a strong dollar in financing the US's large fiscal deficits, emphasizing the dollar's role as the world's reserve currency. However, he also called for future efforts to address the growing federal debt burden, suggesting the establishment of a bipartisan commission to tackle the deficit. Mnuchin's remarks underscore the importance of maintaining confidence in the dollar and the US's financial health over the long term.

Street Views

• Jonny Fine, Goldman Sachs Global Banking & Markets (Neutral on Treasury bonds):

  "The main concern is: Where’s the demand coming from to satisfy all of this supply?"

• Alec Phillips, Goldman Sachs Research (Neutral on US federal budget deficits):

  "Few politicians seem committed to curtailing deficits... In the case of an all-Republican scenario, that probably means extending all of the expiring tax cuts plus probably a little bit more on top of that. A Democrat-controlled Washington will likely increase spending... doing nothing actually, surprisingly, probably results in a slightly smaller deficit than the other scenarios."