Written by Carlos T Mock, MD   

The recent deal extending Bush-era tax cuts is flawed because it fails to send a “signal of austerity” from the US about its ability to reduce its mounting debt burden. Market reaction was swift and devastating. US Treasuries suffered their biggest two-day sell-off since the collapse of Lehman Brothers, following a torrid month that has seen borrowing costs for western governments soar. Germany, Japan and the US have all seen their benchmark market interest rates rise by more than a quarter in the past month while the UK’s has risen by nearly a fifth.

The yield on 10-year US Treasuries hit a six-month high of 3.33 per cent on Wednesday, up 0.39 percentage points from Monday and 1 percentage point higher than its October low. The first toxic consequence of this is increase mortgage rates (which are based on the 10 year Treasury interest rates) thus hurting the housing recovery.

Japanese five-year yields also rose the most in two years, while Germany’s benchmark borrowing costs hit 3 per cent. “People are getting out of the market and moving to the sidelines, feeling shell-shocked at the speed of the rise in yields,” said David Ader, strategist at CRT Capital. US 10-year yields have risen by about 0.76 percentage points since November 8, those of Germany by 0.62 percentage points, the UK by 0.53 percentage points and Japan by 0.29 percentage points as the prices of the bonds has fallen.

Yields are still relatively low compared with long-term trends but investors are starting to fret that they could continue to move sharply higher. “Yields at this level are clearly unsustainable,” said Paul Marson, chief investment officer at Lombard Odier, the Swiss private bank. At what point will the US get stuck in a Japanese styled economy with a very prolonged recovery?

The market moves came after President Barack Obama agreed with Congressional Republicans to extend Bush-era tax cuts and combine them with a $120bn payroll tax holiday. The primary explanation is that growth expectations have increased because of better economic data and the “second stimulus” provided by the US government. But others argue it could be due to fears that the US Federal Reserve will not follow through on asset purchases or because of higher government deficits. “It is probably all three,” said said Steven Major, global head of fixed income research at HSBC.

Bucking the leadership of his own party, Tom Coburn, the Oklahoma senator who last week voted in favor of a sweeping plan to cut US budget deficits by $3,900bn during the next decade, said in an interview with the Financial Times the tax cuts deal did not “address our real problems and the real problem is we are in a hole financially”. The focus of Mr. Coburn’s criticism of the deal was not the overall cost of the tax cut extensions, which he supports, but that no spending cuts were included in order to offset some of the cost.