Bill Dudley, former chairman of the New York Federal Reserve, chairman of the Bretton Woods Committee, and non-executive director of UBS, wrote on Wednesday that the real reason for concern about the huge US budget deficit is not its direct impact on the money market, but the possibility that the "bond market vigilante" will wake up again. The following is the full text.

The U.S. government's fiscal situation continues to deteriorate. The latest forecast from the Congressional Budget Office shows that the government will need to borrow an additional $400 billion this year to cover the budget deficit, and will need to borrow trillions more over the next decade.

Investors have good reason to worry about this trend, but the direct impact on currency markets is not one of the reasons.

The CBO’s forecasts do paint a grim picture. It has raised its 2024 deficit estimate to $1.9 trillion from $1.5 trillion, citing military aid to Israel and Ukraine, student loan forgiveness and higher interest rates. It estimates the deficit will total $22.1 trillion over the next decade, up from a $20 trillion estimate in February — based on the optimistic assumption that Congress will not extend provisions of the 2017 Tax Cuts and Jobs Act beyond 2025.

A further rise in the deficit requires more borrowing. When the Treasury unexpectedly needs to issue more debt, it typically does so by selling short-term Treasury bills, which it can roll over into longer-term bonds if borrowing continues. That has led to concerns that a flood of Treasury bills will hit the market, sucking up cash and triggering a spike in short-term interest rates, like the one that rocked money markets in September 2019.

I don't think the Treasury's increased borrowing would be too disruptive for three reasons.

First, higher-yielding Treasury bills will absorb much of the cash currently parked in the Fed's reverse repo purchase facility, where investors (mostly money market mutual funds) have lent about $380 billion against Treasurys at a yield of 5.30%. As use of the facility declines, that cash will eventually flow to banks, increasing their reserves and reducing their need to borrow short-term.

Second, the Fed is very careful to ensure that banks have ample reserves to meet their liquidity needs, precisely to avoid a repeat of the turmoil of 2019. This month, for example, the Fed slowed its reduction of the limit on its holdings of U.S. Treasuries from $60 billion per month to $25 billion. All else being equal, the more bonds in the Fed's portfolio, the more cash banks have.

Third, the Fed now has a standing repo facility, also in response to the turmoil of 2019. This guarantees that banks can always borrow cash against their holdings of Treasuries, currently at 5.50%—effectively capping short-term interest rates even if demand for cash unexpectedly exceeds banks’ reserves.

So everything seems fine, is there nothing to worry about? Of course not. The United States has been running large and chronic fiscal deficits, which poses huge risks. The more it borrows, the greater the chance of a vicious cycle in which government debt and interest rates inevitably push each other higher. The growing debt burden increases pressure on the Federal Reserve to dilute the debt by allowing inflation to rise - an outcome that could be facilitated by the re-election of Trump as president.

It’s impossible to know when investors will decide that the risk is too great to bear, as the famous “bond vigilantes” did in the 1990s. And when it does, it tends to be sudden and brutal. That’s the most important question.

The article is forwarded from: Jinshi Data