How Much is Too Much?

One of the topics clients ask me about most in recent months is the United States’ level of indebtedness. The U.S. government has over $32 trillion of debt. The economy generates over $20 trillion a year. Whether you think about it in absolute or relative terms, this level of debt is staggering. Given last week’s Congressional machinations and the concern about the fiscal policy, this is an important topic now—not least because of its potential impact on interest rate levels and bond portfolio structures going forward.

Investors are wary of uncertainty … and Congressional dysfunction magnifies uncertainty. That’s true beyond fiscal management, too, of course. The news from Israel over the weekend highlights Congress’ inability to take action. There is no ambassador to Israel because one has yet to be approved by Congress. There also is no one in the military officially responsible for the Middle East. Regardless of your politics, and regardless of your view on the use and projection of U.S. resources, these issues signify dysfunction. For our purposes, today, we’ll stick to the debt—but it’s important to acknowledge the broader context. Our point here is that political dysfunction that leads to fiscal policy uncertainty raises the cost of national debt.

Debt Ratings

On August 1, the Fitch rating agency cited both the level of debt and the political turmoil surrounding both tax and spending policies as a reason to reduce the credit rating on Treasuries from AAA to AA+. Fitch had warned about this potential move since S&P downgraded Treasuries in April of 2011. Fitch stated concerns about the lack of a credible plan to reduce the indebtedness of the U.S. government or the collaboration to choose a better fiscal path.

When announced, the Administration’s view was that this is the smallest of the three rating agencies and so we, the public, shouldn’t be that concerned. When Fitch announced the change, the former Fed Chair and current Treasury Secretary, Janet Yellen, noted that Democrats and Republicans had recently come together to resolve the debt ceiling crisis—suggesting that they can indeed work together. To be clear, they didn’t resolve it … they moved the deadline to November 17. That’s less than 40 days away. And, with no House Speaker, it would seem the probability of a shutdown is higher than a week ago.

Not resolving the debt ceiling issue on time will not only shut down the government; it may also create uncertainty in the minds of Treasury owners.

Treasury Ownership

Among Treasury bondholders are foreign investors such as sovereign states who trade with the U.S. and public/private pension funds.

As you can see from the chart below, Japan, China and the U.K. are the largest owners of Treasury debt. In fact, foreign countries hold almost one quarter of total U.S. debt, or $7.4 trillion.

The less certain that foreign and public/private fund investors are about Congressional willingness to produce a reasonable fiscal policy, the more interest income they may demand to hold our debt.

As interest rates have risen, the cost of this debt has grown, too. In 2022, the total expense was $497 billion or about 8% of total government expenditures. Due to higher interest rates, the cost of debt could rise to almost 11% within a couple of years. Combine that math with stubbornly higher inflation and we could see interest rates remain higher for longer.

The chart below shows the yield of the 10-year Treasury bond. You can see it is up more than 1.3 percentage points since April/May of this year, from 3.5% to 4.8%.

Some of this change could be due to the “term premium” in longer-dated Treasuries. This is the amount of additional yield bond investors require because they are lending the government money for a long time, such as 10 years. There are many factors affecting this premium, some of which are believed to be political stability (here we are back to dysfunction again!), the supply and demand of Treasuries and the volatility of inflation.

The chart below shows how much issuance has risen, and the slow increase in foreign purchases.

This increase in yields is good for bond investors’ future purchases. The fact that real yields and the term premium may remain higher for longer suggests that bonds may begin to provide an alternative to lower-performing company stocks. Many clients may have increased their equity allocation when interest rates were low to earn more. That has worked well as the stock market has generated better than 10% returns over the last several years. We suggest a conversation with your advisor about your asset allocation—as trimming stocks in favor of bonds may be warranted.

The Bottom Line

We’ve answered clients’ questions for a long time saying that the government’s spending and debt creation problem will eventually need to be solved. It has been a topic of conversation almost my entire career. We may now be beginning to see the effects of too much debt in the level of interest rates based on the term premium.

That could represent an opportunity for bond investors and problems for politicians.