President Joe Biden will likely face an economic headwind that no president has faced since Bill Clinton in his first term – rising interest rates as he seeks to set his economic agenda.
The first quarter of 2021 witnessed a meteoric rise in borrowing costs for both the U.S. public and private sectors, with 10-year Treasury yields jumping from around 0.90% to start the year, to about 1.75% to end March. There are very profound questions about what this rise in interest rates means for investors, the housing market, governments, and companies too, but more important questions are “Why did rates rise so quickly?” and “What is it telling us about the next few years?”
On the first question, it’s no surprise that rates increased between December and March – interest rates have been rising steadily since August, as the U.S. economy began to rapidly pull itself out of recession. This is the typical pattern witnessed in the early part of nearly every economic cycle, though the first years of the last decade witnessed the opposite: falling yields, as the recovery was fragile and delayed by poorly timed regulations and tax increases. Still, yields eventually rose by the second half of the last decade once growth accelerated. So, this type of increase in yields is pretty typical. But the acceleration since December is an old but very clear message from the bond market to elected officials in Washington. That message is that the bond market will always have the final say on the magnitude and purpose of government spending. That is to say that borrowing comes at a cost, and when growth is scarce, like it was in the 2010s, the bond market has little incentive to penalize borrowers that continue to pile on debt. But when growth is ample, and better lending opportunities exist, each new dollar of borrowing requires a higher interest rate than prior rounds of indebtedness. In other words, the bond market is still sovereign over the sovereign when it comes to the nation’s checkbook.
The bond market will always have the final say on … government spending.
This is an important observation that has derailed Republican and Democratic agendas over the years. And for the first time in about 25 years, the bond market has awoken from its slumber to challenge the economic agenda of our commander in chief. If President Biden responds the way prior presidents have, he’s likely to whittle down the scope of his economic agenda, so as to avoid collateral damage to the economy, particularly the housing sector, which is finally standing on its own two feet after a dozen years of false starts. But if President Biden chooses to push aside the warnings from the bond market – or even worse, use new regulatory policies to suppress the signal from the market – then the bond market will likely push back, and that’s when households and investors risk becoming collateral damage. We make no forecast on the eventual outcome, and for now we note that the bond market has settled down some since the end of March – an unusual level of patience for a market that’s known to be far more temperamental than the stock market. But if the Biden administration pushes forward with additional stimulus later in the year, it’s likely to trigger another tantrum in the bond market, and the next one may result in both economic and financial market casualties if neither side chooses to back down.
Thomas Tzitzouris is director at New York City-based Strategas Research Partners. He lives in Rhode Island.
