Deficit Pressures Treasuries… But No Crisis: US Treasury Market Is ‘Too Big to Fail'

Despite the projected $3.8 trillion increase in the federal budget deficit over the next decade, RiverFront Investment Group believes it will have a minimal near-term impact on the Treasury market, citing its size, depth, and diversified investor base. While dependence on foreign investors and hedging costs pose challenges, potential buying from U.S. banks, contingent on regulatory changes like the SLR exemption, could offset these pressures. RiverFront anticipates the 10-year Treasury will trade between 4.25% and 4.75%, with a fair value of 4.5%, even amidst ongoing trade and deficit negotiations.

Analysis

The US federal budget deficit, projected by the Congressional Budget Office to increase by $3.8 trillion over the next decade following the House's passage of a new spending bill, is anticipated to have a minimal near-term impact on the US Treasury market. This resilience stems from the market's substantial size, with $28.6 billion outstanding at the end of Q1 2025, an 8.4% increase since end-2023, representing nearly 48% of the US bond market and 19% of the global bond market. The US dollar's status as the world's reserve currency significantly underpins this strength, fostering a diversified investor base. However, weaknesses exist, notably a dependence on foreign investors who held 33% of US Treasuries as of June 2024. While concerns persist about potential selling pressure from geopolitical adversaries like China, particularly amid trade tensions, evidence suggests China may be indirectly maintaining its holdings through conduits like Belgium and Luxembourg. Institutional hedging also poses a risk, though the recent Moody's downgrade of US sovereign debt is viewed as a non-event. An opportunity to mitigate these risks lies in potential US bank buying, should the Trump Administration exempt US Treasuries from the Supplemental Leverage Ratio (SLR) requirement, thereby reintroducing a significant domestic buyer base. Conversely, threats include rising yields in other developed nations and escalating currency hedging costs, which currently erode the yield advantage of US Treasuries for foreign investors, as exemplified by the comparison with 10-year German sovereign bonds. Despite these crosscurrents, the analysis projects the 10-year Treasury yield to trade within a 4.25% to 4.75% range, with a fair value of 4.5%, indicating stability even if trade or deficit negotiations yield negative outcomes.

Key Decisions for Investors

• Investors should monitor the 10-year Treasury yield, expecting it to remain within the 4.25% to 4.75% range, and consider that the substantial market size may absorb near-term deficit-related pressures.
• Pay close attention to developments regarding the potential exemption of US Treasuries from the Supplemental Leverage Ratio (SLR) for banks, as this regulatory change could significantly increase domestic demand and offset any pullback from foreign investors.
• Factor in the impact of rising global interest rates and currency hedging costs on foreign demand for US Treasuries, as this dynamic could pressure yields if domestic absorption, particularly from banks, does not materialize.