The deficits facing the United States have put the nation in the unenviable position of an expensive place to go looking for capital. As the Federal Reserve takes dead aim at higher short-term rates in its quest for normalization, the entire U.S. Treasury yield curve has moved up (Figure 1).  Daily we hear from analysts that the 10yr is going to reach 3% any day now and some are forecasting that the rate has further to run, perhaps, to the mid-3% range. Warnings abound about the negative impact on the stock market should the 3% level be breached. While some welcome the rise in rates as sign of a robust economy, the question remains whether the U.S. economy can tolerate much higher rates given existing the debt levels in government and in nations’ households.

                           Figure 1 The Expected Shift in the U.S. Yield Curve

Whatever one’s view as to whether the higher rates are a “good “or “bad” there is little doubt that the United States is a very expensive place to raise money. Figure 2 measures the spread between the U.S. Treasuries and sovereign debt among the major economies. The spreads in favour of the United States are the more remarkable given that all countries have enjoyed an uptick in growth and in some inflation.

                                             Figure 2 US Bond Spread Over Comparable Foreign Debt

The spreads are particularly noticeable in the case of the EU (Germany) and the U.K. The U.K. has experience relatively higher inflation rates in response to the devaluation of the pound, yet its interest rates are considerably below the U.S. rates at all points along the curve. The U.S. spreads with respect to Canada have widen considerably. Canada enjoys one of lowest government debt- to - GDP ratios among the advanced economies.

What can account for the recent blowout in U.S. rates? The inflation scare earlier in February was not unique to the United States, yet the reaction was more acute. More importantly, investors have taken careful note of U.S.  fiscal stance and have concluded that the huge federal deficits being created with the passage of the tax reform bill warrant higher long-term rates. Recent U. S. Treasury auctions have been relatively well received but at a cost as the yields remain elevated across the spectrum.

Going against textbook teachings, the U.S. dollar has declined as these yields rise. Normally, rising yields should result in some currency appreciation. The failure of the dollar to appreciate in response to wider yield spreads exacerbates the problem for overseas investors who have to hedge against currency losses.

With the U.S. federal deficits on upward trajectory, we can expect these spreads to be maintained and possibly widening further as the Fed sticks to its guns.