How concerning is the U.S. debt level?

Authors: Julia Wang, Yuxuan Tang, Alex Wolf, Global Investment Strategy team

 

Market Recap

July consumer price inflation (CPI) for U.S. was released on Thursday. The report was largely in line with expectations (month-on-month 0.17% vs 0.2% expected). Looking closer, goods prices fell deeper into deflationary territory, and core services excluding shelter (Fed’s proxy for trend inflation) picked up modestly from the previous month but continues to remain soft. This print reaffirms a continued disinflationary trend, and supports a Fed pause at the next FOMC meeting. It also supports our “soft-ish” landing base case - below trend growth over the next year, but no recession – as cooling inflation without too much pain in the labor market reduces the risk of a hard landing. Market reactions on the day were relatively muted. For investors, we think the print is supportive of our preference for extending the duration and a softer dollar on the margin.

 

This week, U.S. equities continued to consolidate from the strong rally over the past months. Treasury yields fell from last week’s highs as angst around the Fitch downgrade of U.S. debt calmed. Outside of the U.S., Chinese equities had a choppy week on weaker than expected macro data and headlines around a missed bond payment by Country Garden (China’s largest private developer by sales). Oil continued to edge up, reaching a new year-to-date high on the week.

 

The key data market is watching this week is U.S. CPI released on Thursday. The report came in largely in line with expectations (month-on-month 0.17% vs 0.2% expected). Looking closer, goods prices fell deeper into deflationary territory, and core services excluding shelter (Fed’s proxy for trend inflation) picked up modestly from the previous month but continue to remain soft. This print reaffirms market a continued disinflationary trend, and supports a Fed pause at the next FOMC meeting. It also supports our “soft-ish” landing base case - below trend growth over the next year, but no recession – as cooling inflation without too much pain in the labor market reduces the risk of a hard landing. Market reactions on the day were relatively muted. For investors, we think the print is supportive of our preference for extending the duration and a softer dollar on the margin.

Strategy Question: How concerning is the U.S. debt level?

U.S. government debt has come into focus in recent times. In May, the U.S. Congress agreed to suspend the debt ceiling, but only after having negotiations come right down to the wire. In recent days, investors have been surprised by large increases in the U.S. fiscal deficit, causing yields on government debt to move higher. Out of concern for these dynamics, last week Fitch downgraded the U.S. sovereign rating from AAA to AA+. The structural mismatch between revenue and spending is already a well-known issue, but high interest rates are putting further pressure on the system. In this note we will address the most frequently asked questions and also discuss implications for investors.

The U.S. government has been running a consistent fiscal deficit since the Global Financial Crisis (GFC), with spending outpacing revenue. This has been possible for two reasons: 1) U.S. Treasuries are the most liquid “risk free” asset in the world and have consistent demand from global governments, corporates, and investors; and 2) in the period after the GFC, the Fed purchased a significant amount of U.S. debt. This was possible because the low inflation environment experienced after the GFC allowed deficit financing by the Fed without the burden of inflation constraints.

It now appears that the annual deficit will only widen in the coming years. Approximately two thirds of the expenses in the U.S. budget are mandatory or nondiscretionary spending, which largely includes retirement and healthcare.  Due to demographic shifts and healthcare costs, this kind of spending is on a structurally rising trend. Interest on expense will likely be 10% of spending and this is expected to grow to 15% by 2033. Meanwhile revenue growth is forecasted to drop (as a share of GDP) in the next few years (due to tax cuts), and then rise modestly alongside income growth. According to this forecast, by 2035 approximately 100% of govt revenue will be needed to pay for entitlements plus interest on the debt. This means that there could be less (or no) space in the budget to pay for all the other goods the Federal govt has been able to spend money on such air traffic control, roads, bridges, space shuttles, the judiciary, vaccines, the FDA, environmental protections etc.

The unique dynamic in this cycle is that fiscal policy has stayed more expansionary despite a strong economy. From the extraordinary stimulus to fight the pandemic, to the semiconductor CHIPs Act, a more proactive use of fiscal policy has helped support a strong economic expansion. At the same time, it has also exacerbated a mismatch between revenue and spending, leading to an increased deficit. According to the Congressional Budget Office (CBO), U.S. federal debt held by the public will be almost 100% of GDP by the end of this year. It is then forecast to rise relative to GDP, reaching 181% of GDP by 2053.

Why should investors care? Over the last ten years discussions of the fiscal trajectory have often ended with a sense of ‘so what’. And indeed, that seems to be the consensus response to the Fitch downgrade. The challenges are well-known and the downgrade does not necessarily change anything.

This of course goes back to the unique role of U.S. Treasuries as one of the most easily investable “risk free” assets in a world with a dearth of similar options as well as the USD as the reserve currency. This means investor demand for U.S. government bonds isn’t directly affected by ratings. While there may be some technical position adjustment, we think the impact from the downgrade is very limited. Furthermore the U.S. government isn’t an outlier. Despite all the panic about rising U.S. government debt, it is roughly in the range of other developed nations. Even China, if local government financing vehicles are included as contingent government debt, debt reaches about 100% of GDP.

But that doesn’t mean the fiscal and debt trajectory is not a cause for concern. In particular, the share taken up by mandatory spending and interest expense is already very high and rising. The CBO expects they will crowd out discretionary spending (approved by Congress during the annual budget) in the coming years. Despite an aggressive rate hike cycle, over the last twelve months the average cost of financing for the U.S. government has only risen from 1.5% to 2.5%. If interest rates stay high, the average cost of financing will go up. A 5% interest rate for the next ten years will see interest expense grow to as much as 30% of total expenses. Such a high debt load could have implications for future budget and growth. If continued at the projected rate, room for fiscal discretion is more limited and comes with a higher burden of interest expense. More limited fiscal policy room could be a constraint, if not a headwind to growth. This is more of a long-term challenge, and means that some type of fiscal reform is likely needed in the coming years. 

Another question is how the market will digest the rising supply in treasuries. In the latest quarterly financing estimates, the U.S. Treasury Department projected a significant increase in Treasury issuance through year-end – namely some $1.8 trillion in net privately-held marketable borrowing over 2H23, which is about $300 billion more than consensus expectations. The August refunding announcement also caught the market by surprise, noting larger auction size increases across tenors over the coming quarters. The demand picture adds a layer of complexity to the story. With the Federal Reserve’s quantitative tightening (QT) process likely to continue through next year, holdings by the central bank could continue to shrink. Remember that the Fed holds ~15% of total U.S. Treasuries outstanding at the moment, and QT is carried out at a pace of around an $80 billion reduction in holdings every month. Some investors are worried about how increased supply of Treasuries from the larger deficit and reduced demand from the Fed will impact bond yields. Treasury markets seemed to be responding to this narrative over the past two weeks with a ~25bps jump in 10-year yields without a clear shift in Fed policy expectations. Furthermore, research from J.P. Morgan Investment Bank suggests these dynamics could put upward pressure on global yields of about 25bps, market moves suggest this is already being priced in. 

While we are closely watching what may be changing in this cycle, we’d note that it’s hard to see the impact of supply on Treasury yields in recent history. As shown in the below chart, the sharp rise in yields in the 1970s took place in a period when debt levels remained relatively stable (debt increased at a faster pace in the 80s when yields fell from highs). While debt levels picked up significantly after the GFC, Treasury yields were on a structural downtrend during the same period. 

We still believe that monetary policy remains the primary driver of  Treasury yields beyond short-lived market volatility. Compared with supply, the federal funds rate has been a much better explainer of the movement in yields over the past 50 years, as shown in the chart below. In a more detailed modeling of yields, we found that most movement in the 10-year Treasury yield can be explained by factors other than supply, including monetary policy expectations, inflation expectations, central bank balance sheet sizes, and economic growth.

This framework is embedded in our outlook for yields over the next 12 months. We expect yields to moderately decline from here, as the Fed is likely done with hiking and may begin to cut rates in 1H 2024 to normalize policies from the current highly restrictive stance. Arguably, with growth in the U.S. looking better than we previously expected, the Fed can cut with a slower pace, which limits the scope for yields to decline over the near-term. However, we don’t think the supply story will reverse the trend.

Another question is how the debt issue may impact the U.S. dollar. We think the direct impact may be minimal. So far we are not seeing any signs of the dollar being dethroned as the world’s primary reserve currency due to debt concerns. Whether looking across the dollar’s use in FX and international trade transactions, its share of central bank FX reserves, or the importance of USD financing to offshore entities, the dollar’s dominant role looks well secured. That said, factors such as interest rates (i.e. level of Treasury yields), as well as U.S. economic growth, are able to drive the value of the dollar up and down like other financial assets. From a portfolio perspective, we encourage investors to diversify their currency exposure – just like one should when it comes to any other asset class.

All market and economic data as of August 10, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

There can be no assurance that any or all of these professionals will remain with the firm or that past performance or success of any such professional serves as an indicator of the portfolio’s success.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

This document may also have been made available in a different language, at the recipient’s request, and for convenience only. Notwithstanding the provision of a convenience copy, the recipient re-confirms that he/she/they are fully conversant and has full comprehension of the English language. In the event of any inconsistency between such English language original and the translation, including without limitation in relation to the construction, meaning or interpretation thereof, the English language original shall prevail.

This information is provided for informational purposes only. We believe the information contained in this video to be reliable; however we do not represent or warrant its accuracy, reliability or completeness, or accept any liability for any loss or damage arising out of the use of any information in this video. The views expressed herein are those of the speakers and may differ from those of other J.P. Morgan employees, and are subject to change without notice. Nothing in this video is intended to constitute a representation that any product or strategy is suitable for you. Nothing in this document shall be regarded as an offer, solicitation, recommendation or advice (whether financial, accounting, legal, tax or other) given by J.P. Morgan and/or its officers or employees to you. You should consult your independent professional advisors concerning accounting, legal or tax matters. Contact your J.P. Morgan team for additional information and guidance concerning your personal investment goals.

Indices are not investment products and may not be considered for investment.

For illustrative purposes only. This does not reflect the performance of any specific investment scenario and does not take into account various other factors which may impact actual performance.

These are presented for illustrative purposes only. Your actual portfolio will be constructed based upon investments for which you are eligible and based upon your personal investment requirements and circumstances. Consult your J.P. Morgan representative regarding the minimum asset size necessary to fully implement these allocations. 

Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

RISK CONSIDERATIONS 

• Past performance is not indicative of future results. You may not invest directly in an index. 
• The prices and rates of return are indicative as they may vary over time based on market conditions. 
• Additional risk considerations exist for all strategies. 
• The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service. 
• Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report.