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Investment Strategy

How concerning is the U.S. debt level?

Aug 10, 2023

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.

Congressional Budget Office annual budget deficit estimates

Billions $

Source: CBO, Haver Analytics. Uses CBO projections for budget deficit. Data as of May 18, 2023.
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.

Debt to GDP expected to secularly rise

Federal debt held by the public to GDP, %

Sources: Bloomberg Finance L.P., Federal Reserve, BEA, Congressional Budget Organization (CBO), J.P. Morgan Private Bank. Data as of July 2023.

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.

U.S. DEBT LEVEL is roughly in the range of other developed nations;

General government debt as % of GDP

Source: IMF Article IV 2022, Table 5. Data is as of 2022. 
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. 

Supply matters but it is hard to see the impact on yields

Federal debt % GDP & 10Y UST yield, %

Sources: Bloomberg Finance L.P., Federal Reserve, BEA, J.P. Morgan Private Bank. Data as of July 2023
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.

FED funds is a much better explainer for Treasury yields

Federal funds rate and 10Y UST yield, %

Source: Bloomberg Finance L.P. Data as of July 2023

Most movement in 10Y U.S. Treasury yields explainable without including debt supply

10Y UST yield and 10Y fair value model, %

Sources: Bloomberg Finance L.P., BLS, BEA, J.P. Morgan Private Bank. Data as of July 2023. 10Y fair value model = regression model using 1Y ahead OIS, 5Y5Y CPI swaps, ISM Manufacturing New Orders Index, and G4 Central Bank balance sheets to explain movements in 10Y UST yield.

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.

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JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states. Please read the Legal Disclaimer in conjunction with these pages.

 

INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

Bank deposit products, such as checking, savings and bank lending and related services are offered by JPMorgan Chase Bank, N.A. Member FDIC. Not a commitment to lend. All extensions of credit are subject to credit approval.