Treasury bond auctions may eventually fail because investors will see federal deficits as too unsustainable, Columbia finance professor warns

• Ballooning government deficits could lead to failed Treasury auction soon, a Columbia Business School professor said.
• Fears about mounting US debt have already worried investors, contributing to a sell-off in bonds.

There are two levers that policymakers use to toggle the amount of money in the markets: monetary policy and fiscal policy. But what happens when one creates a problem for the other?

According to Columbia Business School professor Charles Calomiris, it's a dilemma the US is facing right now. Soon enough, the federal deficit is going to swell to the point where no one will want to take on government-issued debt, and the only people who will save a failed Treasury auction will be the central bank.

"One of the possibilities that's driving bond yields higher is the concerns about inflation risk related to the cumulative effect of debt," Calomiris said in a CNBC interview on Monday. "The possibility that the cumulative effect of deficits will cause money printing to result from the unwillingness of people to bear increasing amounts of government debt, which forces the Fed to step in and purchase the debt, that is, effectively, printing money."

This is how it happens: the US government issues more debt, adding to already large federal deficit. Investors, who are increasingly worried about mounting US deficits, choose to keep their money out of Treasurys. The Fed steps in to buy the unwanted bonds, and they do that by printing more money. This in turn could lead to higher inflation.

"It's really not a question of what the interest rate is going to be, but at some point people will recognize, at no interest rate will they be willing to accept further government debt issues," Calomiris said. "At that point you have some kind of failure of the bond auction."

The bond market has already seen a relentless sell-off, driving yields up at an alarming pace. Last week, yields on the 10-year Treasury punched through 5%, the highest it's been since 2007.

Concerns about the rising federal deficit have been rattling bond investors for a while now, and rising interest rates have also meant that the government has to pay more and more to service that debt, too.

In August, Fitch Ratings downgraded the US government's credit rating, citing "steady deterioration in standards of governance" on "fiscal and debt matters." Some market veterans like Ed Yardeni have said that mounting debt has brought back the "bond vigilantes" who famously dumped US Treasurys in the 1990s in a protest to encourage the government to rein in spending.

Treasury bond auctions have already run into weakening demand. Two weeks ago, the US sold $20 billion of 30-year bonds, but dealers had to take up 18% of the supply, more than the typical share of about 11%.

And according to Calomiris, if the deficit doesn't shrink, demand could weaken further.

"If we don't do something about the cumulative deficits that are being forecasted based on our entitlement programs, we will hit that point, and that will lead to some sort of convulsion in the bond market followed by a very big increase in inflation."