Ballooning US deficit will keep bond yields high, even as inflation cools, market veteran says

• Despite cooling inflation, a growing US deficit will force yields to stay elevated, Ed Yardeni wrote.
• The deficit has widened as tax revenue fell, but costs of federal programs have risen rapidly.
• The 10-year Treasury yield is likely to remain elevated at around 4.25%-4.5%.

Despite declining inflation, the size of the US federal deficit will force bond markets to keep yields high, Ed Yardeni wrote on Monday.

That's as the Treasury Department will be pressured to attract T-bill buyers in order to offset the government's overspending, which is headed for $2 trillion for fiscal year 2023. 

"That's the highest ever excluding during the Covid-19 pandemic, despite Biden's claim that his administration has implemented measures to slash the deficit," Yardeni wrote.

So, even as inflation heads towards the Federal Reserve's 2% target rate, the 10-year Treasury bond is likely to remain elevated at around 4.25%-4.50%, the market veteran said.

Usually, deficits tend to shrink when the economy expands, and widen whenever the US lurches towards a hard landing, given extra spending on stimulus and welfare programs.

"As a result, the ratio of the deficit to nominal GDP is inversely correlated with the unemployment rate and the growth rate of real GDP," Yardeni wrote. "So it is extremely unusual to see the ratio rising—as it is now—at times like now, when the economy is growing and the unemployment rate is near record lows, around 3.5% recently."

Despite growing consensus that a soft landing is likely, he cites this year's tax receipt decline as a partial reason for the deficit. While economic strength was reflected in record highs for payroll and corporate tax receipts, individual income ones fell from a record $2.7 trillion through April to $2.2 trillion over a year through July.

At the same time, the federal outlays are on a more rapid rise, with net interest income, Social Security, and Medicare the top costs. Interest alone has gained $628 billion year-over-year, when measured on a 12-month sum basis.

With costs increasing and a key source of revenue declining, the Treasury will have to rely on borrowing to finance federal spending. 

But with the Fed pursuing a quantitative tightening campaign — that is, allowing assets including T-Bill in its portfolio to mature and roll off without reinvesting the proceeds — and commercial banks focused on stemming deposit outflows, the department will have to increasingly rely on private households and institutional investors to buy its bonds, potentially ratcheting up yields to make them more attractive. 

Increasing the yield may be necessary as net inflows into bond mutual funds and ETFS has dwindled, Yardeni wrote. Through July, they've amount to $189 billion. Meanwhile, money market mutual funds have fared better, with weekly net inflows hitting over $1 trillion through last week.

As of Monday morning, the yield on the 10-year Treasury bill stands at 4.286%, not far from the August high of 4.34%.