US debt risks to become a 'fact of life' for investors, says Citi

By Davide Barbuscia

NEW YORK (Reuters) - Rising U.S. government debt and fiscal deficits that have helped lift government bond yields this year will likely become secondary factors for investors, as their focus shifts to economic fundamentals, Citi analysts said.

Concerns over increased government bond supply and larger fiscal deficits contributed to a surge in government bond yields - which move inversely to prices - to 16-year highs this year, while pushing rating agencies Fitch and Moody's to turn negative on U.S. government creditworthiness.

Even though those challenges are unlikely to recede, investors will eventually grow accustomed to the risks, partly because of lack of alternatives given the U.S. dollar's status of global reserve currency and the depth and liquidity of the U.S. government bond market, said Nathan Sheets, global chief economist at Citi.

"The dollar and Treasuries are the reserve assets ... in some sense investors don't have a lot of other options, and this makes us think the most likely scenario is that these risks recede in the background," said Sheets.

"Our baseline is that over time investors accept these fiscal risks as a fact of life and that ultimately it is not supply and demand that determine Treasury yields but it's more about the fundamentals of the economy," he said.

The nonpartisan Congressional Budget Office (CBO) has estimated that cumulative budget deficits will total about $20 trillion in the coming decade. Moody's, which last week lowered its outlook on U.S. credit, expects the government to continue to run wide fiscal deficits due to increased spending and higher debt interest payments.

Meanwhile, investors have in recent months sounded alarm bells on the U.S. fiscal position. Hedge fund Bridgewater Associates' Ray Dalio expects a U.S. debt crisis. "As we look forward we have a debt problem, because you can't keep adding to debt faster than you add to income," he told CNBC on Friday.

Treasury yields, however, have retrenched in recent weeks on expectations that the Federal Reserve has reached a peak in its interest-rate hiking cycle, and as the Treasury announced a more modest year-end schedule of Treasury debt sales.

Some Fed officials have also said rising bond yields, which make access to credit more expensive, could be a substitute for increasing interest rates further.

"The fact that authorities have to respond to this is potentially how we see the lifecycle of any crisis playing out in the U.S. moving forward," said Jabaz Mathai, head of G10 rates strategy at Citi.

Where authorities have less influence, however, is on the demand side. As the Federal Reserve keeps reducing its bond holdings as it seeks to curb inflation, price-sensitive private investors have to pick up the slack.

"There is going to be an extraction of higher yields from these investors," cautioned Mathai.

(Reporting by Davide Barbuscia; Editing by Ira Iosebashvili and Diane Craft)