2025: Bonds in Charge

Treasurys to Set The Tune This Year

Following two years when equities were the main story, 2025 will likely be the year when yields on US Treasurys start to take the lead in setting the mood for global markets. Developments in the government debt market should have a big say regarding what happens with equities and the overall economy. I base this forecast partly on the inability or unwillingness of the Treasury to reduce the deficit sufficiently to maintain stable yields.

Treasury debt totaled $22.7 trillion on September 30, 2019, which marked the end of the last fiscal year before covid struck. While it would be understandable for the debt to increase as spending rose to combat the impact of the pandemic, debt has continued to surge in the following years despite the strong US economic recovery. Total debt closed out FY 2024 at $35.5 trillion, equivalent to 120% of gross domestic product.

Interest payments on Federal debt amounted to about 14% of total government spending in 2024 and, along with Social Security and Medicare, have become the untouchable “sacred cows” of fiscal spending. In 2024, interest payments exceeded defense spending for the first time in US history. This is one reason why Treasury Secretary Janet Yellen is keen that interest rates come down. However, with the pressure to spend more, she is unlikely to get her wish.

There are additional factors that are likely to keep inflation and Treasury yields elevated. Donald Trump will assume the presidency in just over two weeks, and has promised steps he would undertake on January 20, his first day as President. Two sets of measures, in particular, are likely to have inflationary consequences — import tariffs on the products of some of the most significant trade partners, and a mass deportation of undocumented workers.

Even if some actions end up being negotiating ploys rather than permanent levies, impact of the tariffs is likely to increase US domestic prices, especially if less expensive substitutes are not readily available. Despite Treasury Secretary-designate Scott Bessent’s assertion that the tariff strategy is meant to “escalate [in order] to de-escalate,” imposition of higher tariffs simultaneously on a range of significant trade partners, e.g., China, Canada and Mexico, will likely speed up US prices.

Trump has also threatened to initiate “the largest deportation program of criminals in the history of America” on Day One. Even if the measures to send back undocumented workers are only partially implemented, absence of the workers would be felt in the construction and agriculture sectors which do not have a sufficient number of native-born workers able and willing to replace them. The resulting increase in costs in these two areas will likely be transmitted to the rest of the economy.

Could the push to deregulate businesses, and Trump’s intention to facilitate increased fracking for oil, more than make up for the steps taken on tariffs and immigration, thereby slowing the pace of inflation? Clearly, deregulatory measures would be disinflationary. However, while the impact on prices of higher tariffs and expulsion of workers would be rapid, measures dealing with regulation would take longer to take effect.

Furthermore, the next President will be acting in the presence of a monetary policy that is accommodative. The Federal Reserve lowered the policy rate by a full percentage point in the final months of 2024 — from a 5.25 - 5.50% range in September to 4.25 - 4.50% at year-end. This despite inflation, measured by consumer prices as well as by the Fed’s favorite PCE index, running above the central bank’s 2% target. And although the Fed’s balance sheet of $6.85 trillion is 63% higher than the $4.2 trillion figure at the start of covid in early 2020, monetary authorities are already preparing to end the Quantitative Tightening process — another step toward easing policy.

In addition to these factors that have immediate inflationary consequences, there is also a longer-term demographic feature that would put inflation on an upward trend. US Total Fertility Rate (number of babies born to a woman of childbearing age) has been on a steady decline to 1.67 recently from 3.65 in 1960. Allowing for infant mortality, a TFR of 2.3 is reckoned to be the figure needed to keep the population constant.

A declining TFR would increase the share of the elderly in the population, and lower the percent of the population making up working-age adults. Having fewer hands at work and more mouths to feed is a prescription for higher prices. Improvements in technology and productivity could partly mitigate the impact of demographic shifts but cannot completely offset them.

All these factors suggest that the sharp increase in long-dated Treasury yields since the Fed implemented a 50 basis-point reduction in the Federal Funds rate in September is likely to persist into 2025. Reversing the process would require, not additional Federal Reserve rate cuts, but sensible moves to cut fiscal spending and raise tax revenues.

Dr. Komal Sri-Kumar

President, Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

January 4, 2025

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