Analysts warn that the US lending binge risks market tensions

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The US will be forced to finance a massive increase in its budget deficit with short-term debt, analysts said, with implications for money markets and the fight against inflation.

The Congressional Budget Office, an independent fiscal watchdog, said this week that aid packages for Ukraine and Israel would help push the U.S. deficit to $1.9 billion this fiscal year — compared with its February forecast of $1.5 billion.

“As a country we are spending like a drunken sailor on a weekend ashore,” said Ajay Rajadhyaksha, global head of research at Barclays.

The increase in the deficit has long worried fiscal hawks, who warn that a lack of US discipline will inevitably drive up borrowing costs and that neither President Joe Biden nor his Republican challenger Donald Trump have major plans to shore up the country’s finances.

A more recent shift to short-term funding may also disrupt money markets and complicate the Fed’s anti-inflation efforts.

Part of the expected increase in the deficit is due to student loan forgiveness, which is not expected to have an immediate impact on cash flows.

But Jay Barry, co-head of interest rate strategy at JPMorgan, said the widening deficit would require the U.S. to issue an additional $150 billion in debt in the three months before the end of the fiscal year in September.

He added that he expected most of the funds to be raised through Treasury bills, short-term debt instruments with maturities ranging from a day to a year.

Such a move would raise the total outstanding stock of Treasuries — outstanding short-term U.S. debt — from $5.7 trillion at the end of 2023 to an all-time high of $6.2 trillion by the end of this year.

“The share of Treasury bills in total debt is likely to rise, which opens up the question of who will buy them,” said Torsten Slok, chief economist at Apollo. “That could absolutely put a strain on the funding markets.”

The size of the government bond market has more than doubled since the financial crisis, indicating how much the US has turned to debt financing over the past 15 years.

As the deficit grew, the U.S. Treasury found it increasingly difficult to finance through long-term debt without causing the cost of borrowing to rise uncomfortably. It has increased the proportion of short-term debt it issues – but analysts have warned it risks hitting limits on demand.

Longer government bond auctions are reaching record volumes in some maturities, and the question of who will buy all the debt on offer has plagued economists and analysts for months.

Money market funds — mutual funds that invest heavily in short-term debt — remain big investors in Treasury bills.

But concerns about overall demand are greater as the Fed, the largest owner of US government debt, withdraws from the market and fundamentally changes the balance between buyers and sellers of US bonds.

Analysts warn that if the U.S. floods the market with Treasuries, it could threaten quantitative tightening, the Fed’s effort to shrink its balance sheet, a mainstay of the central bank’s push against inflation.

“The risk is that QT will have to end sooner than expected,” JPMorgan’s Barry said.

The Fed had to step into the markets during the so-called repo crisis in September 2019, when a lack of short buyers sent overnight lending rates above 10 percent.

Rajadhyaksha at Barclays warned that the US could experience a “September 2019 moment” again.