Treasury’s short-term debt strategy faces Fed rate risk

The Treasury Department’s heavy use of short-term borrowing has lowered near-term interest costs, but it has also left a large share of federal debt exposed to any jump in rates. Capital Economics says the risk has grown as Federal Reserve officials take a tougher line on inflation.

The federal debt stands at $39 trillion, and the government has been rolling over large amounts of maturing debt while issuing more, according to figures cited by Capital Economics. The firm said Treasury bills maturing within a year have made up about 85% of federal debt issuance in recent years.

That choice has kept the government tied to the short end of the yield curve, where rates have generally been lower than on longer-term bonds. Capital Economics said 20% of outstanding federal debt is due within four months, with the share set to reach 33% within a year.

Ariane Curtis, senior North America economist at Capital Economics, said in a late-June note that the main threat to the debt burden would be a sharp rise in short-term yields if the Fed raises rates more than markets expect over the next year.

Fed officials sound firmer on inflation

Since Curtis issued that warning, Fed officials have leaned further toward inflation concerns. New Fed Chair Kevin Warsh has recently taken a tougher stance on prices, and other policymakers have indicated less tolerance for inflation that has remained above the central bank’s 2% target for five years.

Cleveland Fed President Beth Hammack said Friday that inflation remains too high and that the labor market is near her estimate of maximum employment. In a social media post, Hammack said businesses have told her they believe the Fed needs to act against inflation, while consumers have described growing financial strain.

Her comments followed a consumer price index reading that came in below expectations, a result that had reduced concern that the Fed would need to raise rates later this month. Even so, the broader tone from the central bank has shifted as the economy has stayed resilient, with half of policymakers expecting rate increases soon.

Bank of America analysts changed their Fed outlook to three quarter-point rate increases this year, Fortune reported, replacing a previous base case that had called for rates to stay unchanged through 2026.

Debt supply and inflation pressures add strain

Energy costs are also adding pressure. The breakdown of the U.S.-Iran ceasefire in the past week pushed oil prices higher again, and the national average price for gasoline has moved back above $4 a gallon, Fortune reported.

Higher energy prices add to cost pressures linked to the AI buildout, which Fortune reported has raised expenses in areas including utilities, consumer electronics and construction. At the same time, the Treasury faces a projected annual budget deficit of $2 trillion and stronger competition for bond investors.

Large technology companies are issuing debt to fund hundreds of billions of dollars in AI spending, according to Fortune. Germany is also preparing to borrow 800 billion euros by 2030 as it expands military spending after decades of fiscal restraint.

Investor appetite for Treasuries has weakened in some corners of the market. Hoisington Investment Management, a bond manager that had favored Treasuries for more than three decades, changed its view, citing expectations for higher inflation and higher yields. Its quarterly report said rising U.S. debt has led investors to require a larger risk premium on Treasury securities.

Capital Economics said the recent rise in Treasury yields alone is not likely to undermine confidence in the federal government’s ability to meet its obligations, even with annual interest costs already at $1 trillion. Curtis warned, however, that sustained high yields would make the debt path more difficult as more securities are refinanced or issued at those rates, while bond markets are paying closer attention to debt levels and fiscal credibility across advanced economies.

This story draws on original reporting from Fortune.