Analysts warn that the US borrowing binge will lead to market tensions

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

The Congressional Budget Office, the independent budget watchdog, said this week that aid packages for Ukraine and Israel could push the U.S. budget deficit to $1.9 trillion this budget year — up from February’s forecast of $1.5 trillion.

“We as a country are spending like a drunken sailor on shore this weekend,” said Ajay Rajadhyaksha, Global Chair of Research at Barclays.

The rise in the deficit has long alarmed budget hawks, who warn that the lack of discipline in the US will inevitably drive up borrowing costs and that neither President Joe Biden nor his Republican challenger Donald Trump have substantive plans to overhaul the country’s finances to support.

The more recent shift to short-term financing could also disrupt money markets and complicate the US Federal Reserve’s anti-inflation policies.

Some of the projected 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 rates strategy at JPMorgan, said the increased budget deficit would require the US to issue another $150 billion in debt in the three months before the fiscal year ends in September.

He added that he expected most of the money would be raised through government bonds, short-term debt instruments whose maturities range from one day to a year.

Such a move would increase the total outstanding stock of Treasury bonds – the US’s unpaid short-term debt – from $5.7 trillion at the end of 2023 to a record high of $6.2 trillion by the end of this year.

“It is likely that the share of government bonds as a percentage of total debt will increase, raising the question of who will buy them,” said Torsten Slok, chief economist at Apollo. “This could absolutely put pressure on financing markets.”

The size of the government bond market has increased fivefold since the financial crisis, an indication of the extent to which the US has turned to debt financing over the past fifteen years.

As the deficit has risen, the U.S. Treasury has found it increasingly difficult to finance through long-term debt without causing an uncomfortable rise in borrowing costs. It has increased the share of short-term debt it issues, but analysts warned there is a risk of exceeding demand limits.

Auctions of longer-dated government bonds are reaching record sizes at some maturities, and questions about who will buy all the debt on offer have plagued economists and analysts for months.

Money market funds – investment funds that invest heavily in short-term debt – remain major investors in government bonds.

But concerns about aggregate demand are growing as the Fed, the largest owner of U.S. Treasuries, withdraws from the market, fundamentally changing the balance between buyers and sellers of U.S. bonds.

Analysts warn that if the US floods the market with government bonds, it could jeopardize quantitative tightening, the Fed’s push to shrink its balance sheet, which is one of the main pillars of the central bank’s anti-inflation policy .

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

The Fed had to enter the markets during the so-called repo crisis of September 2019, when a shortage of buyers briefly pushed short-term loan rates above 10 percent.

Barclays’ Rajadhyaksha warned that the US could experience another “September 2019 moment.”