U.S. Treasuries No Longer a Safe Haven

U.S. Treasuries have functioned as a safe haven for investors during global turmoil for decades. Here’s Investopedia describes their role in providing financial stability:

Treasure bills (T-bills) are debt securities that are backed by the full faith and credit of the U.S. government and, hence, are considered safe havens even in tumultuous economic climates. T-bills are also seen as risk-free, as any principal invested is repaid by the government when the bill matures. Investors, therefore, tend to run to these securities during times of perceived economic chaos.

The perception of U.S. government debt as the world’s premier safe-haven asset is changing. The CEOs of both U.S. and foreign financial institutions warn of the dangers they’ve seen develop in recent years as U.S. Treasuries have become riskier investments.

U.S. Treasuries No Longer Risk-Free

A new paper by Roberto Gomez-Cram, Howard Kung, and Hanno Lustig underscores that change. Presented at the U.S. Federal Reserve’s annual conference in Jackson Hole, Wyoming, in August 2024, it points to the U.S. government’s debt-financed spending response to the coronavirus pandemic as the cause of the change.

Central banks and governments need to ensure that bond markets function smoothly. Before the arrival of COVID, the U.S. had not witnessed large responses to fiscal shocks in Treasury markets in the past decades, including during the GFC. Based on extrapolation from recent U.S. experience, one might have expected Treasury yields to be insensitive to fiscal news when bond markets function well.

The U.S. Treasury market’s actual response to COVID was markedly different from its response during the GFC and more in line with the predictions of standard valuation models. Throughout COVID, U.S. Treasurys were marked down along with the sovereign bonds issued by the governments of other advanced economies, such as France, Germany, and the U.K. We provide direct high-frequency evidence that these U.S. Treasury yield increases were concentrated on days with significant fiscal news, the footprint of the risky debt regime. In a large class of standard asset pricing models, the valuation of the government’s IOUs is marked down when the economy is hit by unfunded spending increases.

In March of 2020, foreign investors did not flee to the safety of U.S. Treasurys. Instead, they sold long-dated U.S. Treasurys in a flight from maturity. The convenience yield on long-dated Treasurys declined throughout the COVID period. During COVID, U.S. Treasurys were not trading as the world’s safe asset of choice, but rather, Treasurys were trading much like the sovereign bonds issued by other mature economies. Towards the end of the sample, AAA corporates are priced as close substitutes for long-dated Treasurys.

In response to COVID, U.S. Treasury investors seem to have shifted to the risky debt model when pricing Treasurys. Policymakers, including central banks, should internalize this shift when assessing whether bond markets are functioning properly. In the risky debt regime, valuations will respond to government spending shocks, which may involve large yield changes in bond markets. In this environment, large-scale asset purchases by central banks in response to a large government spending increase have undesirable public finance implications. These purchases, which provide temporary price support, destroy value for taxpayers but subsidize bondholders. These purchases may also distort the incentives of governments and impair the price discovery in government bond markets. It is not inconceivable that governments in some mature economies have overestimated their true fiscal capacity as a result of these large-scale asset purchases.

That last point is highly significant. Even though the U.S. government’s debt-fueled spending response began as a national emergency under former President Trump, excessive spending continued under the Biden-Harris administration. It continued long after the emergency faded and continues today.

By continuing it, the Biden-Harris administration squandered the opportunity to refill the U.S. government’s credit reservoir to restore its risk-free status. They could have reduced spending to sustainable levels after the pandemic ended, but instead, they failed this basic test of fiscal responsibility.

The national debt in relation to the U.S. economy has now reached levels not seen since the end of World War 2. It may be helpful to consider how politicians of that time tackled this challenge. After the war, they adjusted their spending habits and stopped investing money in a war that had already ended. This decision ensured that the U.S. government’s credit reservoir would be replenished for future generations.

It’s a history lesson that today’s politicians either never learned or have chosen to ignore. Because they haven’t heeded the lesson, debt issued by the U.S. government has become riskier to the nation’s creditors. Because it has become riskier for those who lend money to the U.S. government, that same debt has become much more costly to U.S. taxpayers.

“If something cannot go on forever, it will stop.” It’s only a question of when and how painful it will be when it does.