Treasury yields haven't been this high in years - and the fiscal math gets uglier the longer they stay there

Skepticism is growing about Treasury Secretary Scott Bessent's "big tool kit" when it comes to the bond market.

The Federal Reserve looks all but certain to hike interest rates on Wednesday, even though it would risk making the large U.S. debt burden more precarious to manage.

Fed Chairman Kevin Warsh could improve his inflation-fighting bona fides by raising short-term rates by 25 basis points. Doing so may staunch the sharp selloff in the $31.5 trillion Treasury market that has pushed long-end yields to their highest levels in decades.

Bond buyers were starting to return after the benchmark 10-year Treasury yield BX:TMUBMUSD10Y hit 5% on Monday, said John Velis, BNY's Americas macro strategist. That's a switch from when yields were below that threshold, he noted.

Yet a rate hike - or a few- wouldn't end the Iran war, nor erase the costs associated with the roughly 80% spike in U.S. (CL00) and global (BRN00) crude-oil prices this year. Those factors could make bonds less valuable, because inflation erodes what a fixed income can buy.

Traders had the odds above 90% for an interest-rate hike on Wednesday, according to the CME FedWatch Tool. That might be a deciding factor for some on the Fed's rate-setting committee. Yet a series of hikes could hurt the bull market in stocks or endanger the U.S. economy. They also risk increasing borrowing costs at a crucial moment for the federal government's fiscal picture.

"Rate hikes aren't costless," BNY's Velis said.

Debt costs surge

With the U.S. national debt now topping $40 trillion, the interest expense alone now eats up almost 20 cents of every dollar of revenue earned by the government, according to the Committee for a Responsible Federal Budget, a fiscal-policy think tank.

That's up from less than 10 cents on the dollar in 2007, as the below chart shows.

The U.S. already spends about 20 cents out of every dollar of revenue on interest costs. The share is only set to grow.

"I do feel there's kind of a perfect storm happening," said Robert Sockin, chief U.S. economist at PGIM - pointing to the growing U.S. debt and deficit, sticky inflation, the artificial-intelligence build-out's huge funding needs and other factors weighing on bonds.

Yields of 5% may be taken in stride, but hitting 5.5% or 6% on the 10-year note would be more concerning, Sockin said.

The bond-market selloff already prompted Treasury Secretary Scott Bessent to increase buybacks of long-dated U.S. Treasurys from September through early November. But that's had only a muted impact on rising yields.

Higher yields recently pushed the 30-year fixed mortgage rate back above 7%. It has also raised corporate borrowing costs and made refinancing maturing U.S. debt more expensive.

Short-term thinking

The Trump administration has said it wants lower long-dated yields. Yet Bessent has adopted his Democratic predecessor's use of heavy reliance on short-term Treasury bill issuance to help fund the nearly $2 trillion U.S. budget deficit.

As a result, almost 33% of U.S. public debt will mature in a year or less, and another 35% within five years, according to Treasury data.

"I don't know that the front end is the optimal place to be borrowing right now," said Mark Malek, chief investment officer at Siebert Financial.

The Fed may hike rates only once this year - but historically, the trend has been for several rate increases in a row. Furthermore, President Trump repeatedly badgered former Fed Chair Jerome Powell to lower rates. But Bessent's "Operation Twist" looks likely to drive up short-term rates just as the government plans to focus more of its borrowing there, Malek noted.

About the 'big tool kit'

When asked in August about the size of the increased Treasury buybacks, Bessent said the administration has "a big tool kit, so we'll see."

However, yields continue to climb with the Iran war now in its seventh month, and the buybacks still need to be funded somehow. Tapping the Treasury Department's roughly $900 billion "checking account" for buybacks only delays the eventual issuance of more U.S. debt. That likely means more Treasury bills.

"It's not real firepower, so to speak," said Sockin, the PGIM economist. He added that he's "very skeptical" of Bessent's talk of a "big tool kit."

Unlike the Federal Reserve, "the Treasury can't print money at the end of the day," Sockin said.

-Joy Wiltermuth