ORLANDO, Florida, May 21 (Reuters) - TRADING DAY

Making sense of the forces driving global markets

By Jamie McGeever, Markets Columnist

U.S. debt despair

Investors' unease about holding long-dated sovereign debt

was magnified by a soft 20-year U.S. Treasury note auction on

Wednesday, which slammed the dollar and stocks, pushed long bond

yields higher and steepened the U.S. yield curve.

In my column today I take a closer look at the rising term

premium on U.S. debt. How much higher can it go? More on that

below, but first, a roundup of the main market moves.

I'd love to hear from you, so please reach out to me with

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If you have more time to read, here are a few articles I

recommend to help you make sense of what happened in markets

today.

1. Weak U.S. economic outlook persists despite brief

trade

truce with China

2. What's in the Republican tax and spending plan?

3. Target cuts annual forecasts as tariff pressure

mounts,

demand slows further

4. Japan's portfolio reshuffle raises red flag for

U.S.:

Mike Dolan

5. UK inflation jumps in April, raising prospect of

BoE

rate cut delay

Today's Key Market Moves

* Wall Street slides across the board, with the S&P

500

losing 1.6%, the Nasdaq 1.4%, the Dow 1.9%, and the Russell 2000

small-cap index shedding 2.6%.

* Treasury yields surge as much as 13 bps at the long end of

the

curve - 10-year yield scales 4.60%; 20-year and 30-year yields

hit 4.13% and 5.10%, respectively, both the highest since

October 2023.

* Another down day for the dollar, as the dollar index falls

0.5%,

with the euro, Aussie dollar and yen the big winners.

* The Japanese yen rallies for a seventh consecutive day, a

winning streak last seen in March 2017.

* Bitcoin rises to a record high just shy of

$110,000,

before easing back after the soft U.S. 20-year bond auction.

Bond alarms ring louder

After a poor 20-year government bond auction in Japan on

Tuesday, it was the turn of a weak sale of 20-year U.S. debt on

Wednesday to cast a cold, dark shadow over world markets and put

investors on the defensive.

The trouble is, when supposedly safe-haven sovereign bonds

are at the root of the deepening market angst, the selloff takes

on a more worrisome significance. And when it's U.S. Treasuries

specifically, the cause for concern is even greater.

Wednesday's auction of 20-year notes, the first sale of U.S.

government debt since Moody's stripped the U.S. of its triple-A

rating last week, drew softer demand than usual, but what soured

sentiment and risk appetite was the high yield investors

demanded.

That was always going to be the case really - investors of

all stripes from every corner of the world will buy Treasuries,

the only doubt is the price. It was clearly lower than expected

on Wednesday, and markets reacted accordingly.

Washington's fiscal profligacy remains a major source of

anxiety for bond investors. Non-partisan analysts say President

Donald Trump's tax-cut bill proposals will add between $2

trillion and $5 trillion to the $36 trillion federal debt over

the next decade.

The 20-year Treasury note auction provided fuel for the bond

fire, but fixed income was already smoldering on Wednesday -

long-dated Japanese yields were at record highs and figures

showed UK inflation rose much faster than expected to 3.5% in

April, the highest in over a year.

Tariffs, monetary stimulus, rising debt levels, poor fiscal

discipline, growing policy risk, sticky inflation and soaring

inflation expectations - these are some of the reasons investors

around the world are reluctant to go long 'duration', or buy

long-dated bonds. It's a potent mix, and all markets are feeling

the heat.

U.S. markets, in particular, are under pressure as the rest

of the world reevaluates its holdings of dollar-denominated

assets in light of Trump's global trade war and drive to upend

the world economic order of the past 80 years.

Steep declines in U.S. stocks, Treasuries and the dollar on

Wednesday point to a nervy global session on Thursday.

How much higher can the U.S. term premium go? A lot

Financial markets have had a fairly muted reaction to

Moody's decision to strip the United States of its triple-A

credit rating last week, fueling hopes that the action will do

little long-term damage to U.S. asset prices, as was the case

when the U.S. suffered its first downgrade in 2011.

But given today's challenging global macroeconomic

environment and America's deteriorating fiscal health, that may

be wishful thinking. To monitor the impact in the coming months,

a key indicator to watch will be the so-called 'term premium' on

U.S. debt.

When Standard & Poor's Global became the first of the three

major ratings agencies to cut America's top-notch rating in

August 2011, there was little blowback because Treasuries were

still widely considered the safest asset in the world. Demand

for U.S. bonds went through the roof, despite S&P's landmark

move, and yields and the term premium plummeted.

That's unlikely to happen now.

In 2011, the U.S. debt/GDP ratio was 94%, a record at the

time reflecting a surge in government spending in response to

the 2008-09 Global Financial Crisis. But the fed funds rate was

only 0.25%, and inflation was 3% but falling. It dropped to zero

a few years later and did not return to 3% until the pandemic in

2020.

It's a vastly different picture today. U.S. public debt is

around 100% of GDP and projected to rise to 134% over the next

decade, according to Moody's. Official interest rates are above

4%, inflation is 2.3% but expected to rise as tariff-fueled

price hikes kick in. Meanwhile, consumers' short- and long-term

inflation expectations are the highest in decades.

And while the $29 trillion Treasury market is still the

linchpin of the global financial system, increasing U.S. policy

risk is prompting the rest of the world to rethink its exposure

to U.S. assets, including Treasuries - 'de-dollarization' is

underway.

HISTORICALLY LOW

Put all that together, and it's easy to see why the 'term

premium' - the risk premium investors demand for holding

longer-term bonds rather than rolling over short-term debt - is

liable to rise after this downgrade, unlike 2011. Especially

given its relatively low starting point.

True, the term premium was already the highest in a decade

before the Moody's downgrade on Friday, and is now 0.75%, or 75

basis points. But that is still well below the level in 2011 and

slim by historical standards.

In July 2011, the term premium on 10-year Treasuries was

over 2.0%, but quickly slumped after the S&P downgrade the

following month to below 1% and was negative within a few years.

Treasuries were downgraded, but their status as the world's

undisputed safe-haven asset remained intact.

The last time Uncle Sam's debt or inflation dynamics were as

concerning as they are today, the term premium was much higher.

It rose to 5% during the 'stagflation'-hit 1970s, and was around

4% following the 'Volcker shock' recessions in the early 1980s

triggered by the Fed's double-digit interest rates to quell

double-digit inflation.

"The term premium has come up quite a bit recently and is

likely going to rise more given the fiscal challenges the U.S.

is facing," notes Emanuel Moench, professor at Frankfurt School

of Finance & Management and co-creator of the New York Fed's

'ACM' term premium model.

"The worry some investors might have is a self-fulfilling

debt crisis - a high debt/GDP ratio increases interest rates,

which raises the interest rate burden of the government and

means you can't so easily grow yourself out of this anymore.

This may push the term premium higher."

FEEL THE SQUEEZE

The question is, how high can it go?

History suggests it can go a lot higher until Washington

exerts some serious fiscal discipline, or until the squeeze on

households, businesses and the federal government from higher

market-based borrowing costs gets too much.

Some analysts reckon another 50 basis points this year,

which would take the 10-year yield up to around 5.00%, a pivotal

level for many investors and the historical post-GFC high from

October 2023.

With fiscal uncertainty so high and policy credibility so

low, it's a "tenuous" time right now for Treasuries, as Moench

notes. The global environment is nervy too - Japan's 30-year

yield this week soared to a record high.

BlackRock Investment Institute strategists point out that

long-term Treasuries still carry a "relatively low risk premium

versus the past", and their "starting point" in their portfolio

construction is to assume a rising term premium and "persistent"

inflation pressure. They are underweight long-dated Treasuries.

Treasuries will always attract buyers. It's just that the

clearing price they accept may be lower, and the term premium

they demand may be higher. The risk now is it's a lot higher.

What could move markets tomorrow?

* India, Japan, UK, Germany, euro zone, U.S. flash PMIs

(May)

* ECB's De Guindos, Escriva speak in Madrid

* BoE's Sarah Breeden, Swati Dhingra, Huw Pill speak at

various

events

* Richmond Fed President Thomas Barkin, New York Fed

President

John Williams speak at separate events

* U.S. weekly jobless claims

* U.S. 10-year TIPS auction

* G7 finance ministers and central bank chiefs meet

in

Canada

Opinions expressed are those of the author. They do not

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