The fiscal deficit surges in the US election year: the possibility of US Treasury yield curve control

   In the 2024 US election year, the fiscal deficit is expanding at an alarming rate - the Treasury Department expects the deficit to exceed $1.7 trillion this fiscal year, an increase of 23% from 2023, equivalent to an additional deficit of $4.7 billion per day.

Under the campaign game of the Biden administration expanding clean energy subsidies and Trump promising the "biggest tax cut in history", the issuance of US Treasury bonds has soared to the highest level since the Cold War.

At the same time, the 10-year US Treasury yield fluctuated at a high of 4.5%, and the inversion of the 30-year and 2-year yield curves has lasted for 18 months, the longest record since 1978.

Behind this deficit carnival, a key question has surfaced: Is it possible for the Federal Reserve to restart "yield curve control" (YCC) - a policy tool that was born during World War II and briefly revived during the 2020 epidemic? If implemented, how will it affect global asset pricing? 

Part I: Deficit Storm - How the political cycle hijacks fiscal discipline

1.1 "Spending Competition" in the Election Year

Democratic Strategy: Clean energy subsidies in the Inflation Reduction Act have exceeded expected spending by 42%, and battery factory investment in key swing states (such as Michigan) has surged;

Republican Promise: Trump's "All-Staff Tax Cut 2.0" plan is expected to reduce fiscal revenue by $2.4 trillion (Tax Foundation data);

Rigid Expenditure Expansion: Social Security and Medical Insurance spending increased by 12% year-on-year, and interest payments exceeded the defense budget for the first time (estimated to reach $870 billion this fiscal year).

1.2 The “digestion dilemma” of the U.S. bond market

Issuance peak: Net issuance in Q2 2024 reached $1.1 trillion, and the proportion of foreign buyers dropped to 30% (48% in 2010);

Maturity structure deteriorated: The proportion of bonds with a maturity of more than 10 years exceeded 40%, and the demand of pension funds and insurance companies was saturated;

Liquidity alert: The U.S. bond market depth index (a measure of the bid-ask spread) deteriorated by 65% ​​compared with 2019 (New York Fed data).

Key turning point: When the 30-year yield exceeds 5%, the Treasury’s debt repayment cost will exceed the GDP growth rate (currently 4.9% vs 3.1%), which may trigger policy intervention.

Part II: YCC 2.0-Assessment of the Fed’s “Policy Arsenal”

2.1 What is yield curve control?

Core mechanism: The central bank suppresses the interest rate of a specific term within the target range through unlimited bond purchases (such as anchoring the 10-year yield at 0.7% in 2020);

Historical cases: US wartime YCC from 1942 to 1951, Japan's YCC practice from 2016 to the present.

2.2 Four prerequisites for the current implementation of YCC

Long-term interest rates out of control: If the 30-year yield exceeds 5.5%, it may cause the mortgage market to freeze;

Signal of a hard landing of the economy: The unemployment rate has been above 4.5% for three consecutive months (currently 3.9%);

Pressure on the Ministry of Finance: The proportion of interest expenditure in fiscal revenue in a single quarter exceeds 15% (currently 11%);

Political consensus: No matter who is in power after the election, debt monetization is required.

2.3 Potential operation modes

Moderate version: only control the 5-year yield (currently 4.2%) to avoid short-term interest rate distortion;

Radical version: synchronously anchor the 10-year/30-year period, but need to cooperate with QE4 (estimated scale of 2 trillion+);

Black swan version: directly finance the fiscal deficit (modern monetary theory practice).

Part III: Global market impact deduction

3.1 Game between the US dollar and gold

US dollar index: YCC may plummet to below 100 in the early stage (liquidity overflow), but will rebound if it triggers inflation expectations;

Gold: Under the suppression of real interest rates, the gold price may exceed US$2,500/ounce (currently 2,350).

3.2 Differentiation of US stock sectors

Beneficiaries: utilities (low interest rate preference), biotechnology (lower financing costs);

Losers: bank stocks (narrowing net interest margins), cash ETFs (yield lock).

3.3 The butterfly effect in emerging markets

The revival of carry trade: borrowing low-interest yen to buy high-interest currencies such as the Mexican peso;

Sovereign debt risk: If US debt loses its pricing benchmark, the interest rate spread of US dollar bonds in developing countries may surge.

Part IV: Controversy and risk-Is YCC really a cure?

4.1 Supporters' arguments

Nobel economist Stiglitz: "In an era of political polarization, YCC is the last firewall to avoid debt crises";

Goldman Sachs model: Keeping the 10-year yield below 4% can reduce the probability of a recession in 2025 by 12%.

4.2 Opponents' warning

Former Federal Reserve Chairman Ben Bernanke: "YCC will distort capital allocation and repeat Japan's mistakes of losing 30 years";

Market autonomy: The open interest of US 10-year Treasury futures shows that the probability of hedge funds betting on YCC failing is 61%.

4.3 Unspoken costs

Inflation spiral: During the period of YCC implementation in the United States from 1946 to 1951, the average annual increase in CPI reached 7.8%;

Loss of independence of the Federal Reserve: The Treasury Department may permanently dominate monetary policy.

Standing at the time node of the third quarter of 2024, YCC has been upgraded from academic discussion to market pricing with a probability of 25% (based on the implied volatility of federal funds rate futures). For investors with different strategies:

Hedge funds: long volatility (buy US Treasury option straddle combination);

Long-term allocators: increase holdings of inflation-resistant assets (gold, TIPS);

Policy arbitrageurs: pay attention to the convergence opportunities of 5-10 year US Treasury yield spreads.

Finally, remember - in election years, fiscal discipline is often the first to be sacrificed. And when the music stops, those who hold cash may not be the winners, but those who understand the score will definitely find a chair.