A “monster?” A “time bomb?” How to see the real danger from U.S. debt

U.S. government debt does not pose the risk you think it does.

For decades, market watchers (and others) have warned about a national debt crisis. In 1996, Schoolhouse Rock likened the U.S. debt load to a prehistoric monster that eats an unfair share of tax revenue, singing “to let it grow unchecked like this is certainly unwise.” The St. Louis Federal Reserve argued in 2009 that the trajectory of the debt was a “time bomb.”¹. In 2016, Time magazine called the nation the “United States of Insolvency.”²

In other words, the worry is nothing new. More importantly, we think it’s focused on the wrong risk. Rather than a sudden catastrophe, investors should fear a slow, deliberate transfer: Policymakers tolerating stronger growth and more inflation, lowering real interest rates so the debt ratio falls. Over time, this would significantly impair the real value of sovereign bonds, while volatility of rates markets could increase.

For that reason, we believe the cost of growing debt would not appear as a dramatic single moment in markets.³ Instead, it would show up in a loss of purchasing power, especially for sovereign bondholders. While an independent central bank could prevent this dynamic, markets are increasingly concerned that the independence of the Federal Reserve (Fed) is being eroded.

The theory of a debt crisis

We believe the key relationship to watch is between the interest paid on debt and the growth rate of the economy. If the economy (as measured by GDP) is growing faster than interest, the debt-to-GDP ratio should still rise, but not in an alarming, or convex, manner.

Indeed, in four of the last five years, the growth rate of the economy has exceeded the average interest paid on debt. As of today, structural growth remains higher than the borrowing cost on debt. That’s a positive gap that should keep the growth of the debt-to-GDP ratio in check. However, if this relationship were to turn negative and real yields exceeded GDP growth, we could see a rapid increase in the debt-to-GDP ratio.

There is also a risk that interest payments could become so great they would overwhelm monetary policy and contribute to greater inflation. At present, we see very little evidence that this is playing out in the United States.

U.S. debt in reality

People focused on a debt crisis believe there is wisdom in Margaret Thatcher’s famous line: “You eventually run out of other people’s money.” However, there are no signs today that markets are unwilling to finance the United States government.

Households (both directly and through mutual funds) and foreign investors have remained avid buyers of newly issued U.S. debt. In July, when Treasury auctioned $42 billion worth of 10-year notes, buyers lined up with demand that exceeded supply by 2.5 times.⁴ This demand has kept interest rates in check even as the government debt load has soared.

Four recent economic studies have found that downward pressure on interest rates from an aging population and demographic trends have more than offset the upward pressure from increasing government debt over the last few decades.

This dynamic appears likely to persist: Economists from the National Bureau of Economic Research recently found that demand for U.S. government debt is set to outpace supply for the next 50 years.⁵

In other words, despite these long-lived concerns about excessive debt, global savers still consider the U.S. Treasury market the best option, and the dollar remains entrenched as the world’s currency.

Some investors also fret about the implications of the United States being heavily indebted to foreign nations such as Japan and China. However, the share of national debt held by foreigners peaked in 2008 and has declined by almost 20 percentage points since. As this chart shows, China now holds less than 5% of all publicly held U.S. long-term Treasury securities.⁶

What debt crises look like

What, then, does history say about “debt crises?” The last time the United States flirted with one, in the 1930s, Washington did not stiff its creditors—it devalued the dollar relative to gold and voided clauses that allowed bondholders to be paid in gold. Many scholars describe this as a shadow default.⁷ More broadly, since 1900, true sovereign defaults have usually followed defeat or regime collapse after war (e.g., Germany and Japan after World War II and the U.S.S.R. after the Cold War).

Ultimately, markets are viewing U.S. debt with the rational view of an underwriter, not the sensational view of a bond vigilante. Investors know the country’s strengths: A dynamic economy driven by a consistent track record of innovation at scale suggests that the tax base ought to grow. Further, U.S. tax collections as a share of GDP are near the low end among OECD nations, suggesting there is space to raise revenue if necessary.

But that doesn’t mean investors can ignore the debt, especially if the Fed’s independence is challenged.

Greater government deficits and higher debt loads could create incentives for policymakers to constrain the central bank’s independence and lean on looser monetary, fiscal and regulatory settings to boost nominal growth. As the economy expands, the debt-to-GDP ratio falls mechanically—and the real value of existing government bonds erodes.

U.S. history offers a precedent. After World War II, when the national debts surpassed the GDP for the first time, the Fed agreed with Treasury to cap yields at negative real levels, while robust growth helped shrink the debt burden.

While we doubt policymakers would return to such explicit financial repression today, the current backdrop—rate cuts alongside low unemployment and sticky inflation—warrants attention. The historic example shows the real risk for Treasury bondholders is stronger nominal growth both from prices and real economic activity—mundane in theory, and benign for risk assets, but potentially very costly for sovereign bond portfolios in practice.

Takeaways for investors

In our view, equities should provide an important inflation hedge (after all, companies are the ones driving higher prices). But investors with lower risk tolerance should consider more creative strategies to navigate this environment. Infrastructure, gold and strategies such as hedge funds that are less correlated to bonds can defend against a prolonged period of above-target inflation and a steeper yield curve.

Infrastructure offers real-asset cash flows, while gold benefits from demand both from central banks and investors hedging against inflation. The backdrop for hedge funds looks much brighter today than it did 10 years ago, especially as the correlation between stocks and bonds remains elevated. Finally, equity-linked structured notes have the potential to provide returns in the high-single digits with similar volatility to other forms of extended credit, without direct exposure to higher or more volatile interest rates.

Despite the growing probability of a higher nominal growth environment, core fixed income can still be a valuable shield against the risk of slower growth and recession. For U.S. taxpayers, we believe municipal bonds are compensating investors well for perceived risk around higher inflation.

Investors shouldn’t fear a sudden panic over government solvency, but they should prepare portfolios for the risk of elevated inflation and more volatile sovereign debt markets.

We can help

To learn more about how you can invest to take our view of federal debts and markets into account, contact your J.P. Morgan team.