ROI-Long bond blues? US has a short-term debt problem too: McGeever

By Jamie McGeever

ORLANDO, Florida, May 14 (Reuters) - The U.S. long bond has been in the spotlight recently, with the 30-year Treasury yield piercing 5% and nearing its highest level in two decades. But Washington has a short-term debt problem too.

Borrowing costs at the front end of the curve - maturities up to and including two years - are spiking higher, sitting at or near 4%, as the energy shock triggered by the Iran war lifts inflation and dims the prospect of Federal Reserve interest rate cuts.

The rise in long-dated yields - Wednesday's 30-year auction sold above 5% for the first time since 2007 - has grabbed headlines, but yields at the front end have actually spiked by even more. The two-year yield is up 50 basis points this year, while the 30-year yield is up 20 bps.

For a Treasury that needs to issue and roll over huge amounts of short-term debt, this is a worry.

U.S. issuance of front-end debt has more than tripled in the last decade, and now exceeds 100% of GDP, according to analysts at BlackRock.

Bill issuance in the first four months of this year totaled $9.14 trillion, some 85% of the total Treasury borrowing. That's the highest share since the Global Financial Crisis.

Issuing and refinancing at the front end is a logical strategy if there is a "normal" sloping yield curve, where the interest rates on short-term securities are lower than those on longer-dated debt. But doing so also leaves the Treasury highly exposed to rising financing costs, and the strategy seems less smart when the Fed is leaning towards raising the policy rate and the curve is flattening.

"While the issuance of short-term Treasury bills might make sense in the short run," Joseph Brusuelas, chief economist at RSM USA, argues, "the over-reliance on the strategy opens up the possibility of distortions in the financial markets and increased risk of higher costs should inflation spike higher."

LET ME ROLL IT

None of this means a U.S. debt crisis is in the works. If the risk of a buyers' strike is slim at the long end of the curve, it is infinitesimal at the ultra-short end. There will be a long line of investors willing to buy bills and two-year notes in the most liquid market on the planet in return for an annual yield of 4%. The near-$8 trillion balance of U.S. money market funds speaks to the enormous appetite for U.S. bills.

And let's not forget, the Fed is buying around $40 billion of bills every month as part of its liquidity management to ensure there are sufficient reserves in the banking system.

The more realistic risk is that a vicious cycle is being created that could crimp the U.S. government's fiscal policy options.

Unless Washington starts cutting spending or raising taxes -unlikely prospects no matter which party is in the White House - it will need to borrow more to maintain current and future commitments, and that refinancing and new borrowing will need to be done at ever higher rates. Extrapolate out, and the longer-term picture is one of persistently large budget deficits and an elevated debt-to-GDP ratio.

Washington's spending on interest payments already accounted for almost half of last year's $1.87 trillion discretionary outlay, and the non-partisan Congressional Budget Office projects net interest payments in fiscal year 2026 will top $1 trillion, more than the defense budget.

What's more, higher short-term rates may unintentionally widen the budget deficit by increasing debt servicing costs, "potentially reinforcing the very inflationary pressures they are meant to contain," David Andolfatto, professor of economics at Miami University, wrote this week.

He notes that the average rate on marketable federal debt at the end of last year was around 3.5%, nearly three times higher than its level five years earlier. It will be higher than that now, and is likely still heading upward.

So Treasury officials may not be losing any sleep over a weak debt auction or two, but the spiraling cost of funding an expanding government deficit might keep a few of them awake at night.

(The opinions expressed here are those of the author, a columnist for Reuters)

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(By Jamie McGeever Editing by Marguerita Choy)