The non-partisan Congressional Budget Office recently released its publication, The budget and economic outlook: 2021 to 2031, noting that in 2020, US public debt held by the public rose to 100% of GDP for the first time since the end of World War II. These high levels of US debt, so worrisome at the start of the 2010s, when the markets focused on southern European sovereign borrowing above 100% of GDP, will they be a concern for managers today? high quality, high yield US bond portfolios?
High yield, good quality market participants have so far shown no fear of the national debt. In fact, their only fear last year seemed to be missing out, with bond issuance in 2020 breaking records across the risk spectrum.
But 10 years ago, financial markets focused on the sovereign debt burden of southern European countries. As Greece, in particular, was on the brink of default, investors responded by pushing down equity and debt markets, including sovereigns, and pushing the euro lower against the euro. American dollar.
Then Mario Draghi took over the European Central Bank in November 2011. He quickly cut interest rates, and next summer said he would do “whatever it takes to preserve the euro. And believe me, that will be enough ”.
The markets believed it, eventually recovering thanks to liquidity from the International Monetary Fund, Eurozone financial support vehicles and austerity measures, along with interest rate moves and the hype by Draghi.
But nations, to this day, have continued to maintain high levels of debt relative to GDP. In the United States, there is over $ 21 trillion in public debt. Note that the $ 21 trillion figure is “public debt,” which does not include intragovernment debt held by US government trust funds, such as Social Security, which totals approximately $ 6 trillion.
Nothing to see here?
Despite clear market concerns about the high levels of sovereign debt-to-GDP levels in 2011, the US’s rise to the 100% Club has some observers questioning whether investors should now focus their attention on potential ramifications of these high debt levels.
“One hundred percent, that’s not what we thought,” says Joe LaVorgna, former chief economist of the White House and former chief economist of the Americas, at asset manager Natixis. “The markets don’t care because rates are so low, and even lower in Europe.”
According to LaVorgna, according to the CBO, from 2010 to 2020, the United States’ national public debt more than doubled – from $ 9 trillion to $ 21 trillion. Yet, over the same period, the gross interest cost of that debt increased only 26%, from $ 414 billion to $ 523 billion. The CBO attributes the shift in interest cost to “historically low interest rates.”
Viewing interest costs through the lens of US GDP confirms the current low interest rate environment. In the 1970s, net interest on the national debt was no more than 1.5% of GDP. By 1985, this cost had climbed to over 3% of GDP. But by 2020, net interest had fallen to 1.6%. On a relative basis, the cost of the national debt is now half the cost of 10 years ago, and no worse than almost half a century ago.
Part of what keeps intermediate rates at 1970s levels, LaVorgna says, is the purchase of Federal Reserve bonds as part of quantitative easing. Fed purchases, both through Treasury open market operations and through Treasury purchases, mortgages and other non-government bonds, increase the scarcity value of debt securities, thereby increasing the scarcity value of debt securities. which keeps their interest rates low.
Pete Cecchini, founder and chief strategist of Alphaomega Advisors LLC and former global chief strategist at Cantor Fitzgerald, agrees. Expanding on the explanation, he says that QE is a form of “duration transformation”.
Cecchini says that buying the Fed under QE creates a reserve liability on its balance sheet, while buying Treasury bonds creates a compensating Fed’s balance sheet asset. The reserves, residing in member banks, mean that the Fed has effectively replaced a longer-term bond with the shortest risk-free asset available – cash. This process creates demand for treasury bills and lowers yields.
Cecchini believes that the high debt of the US government is not necessarily harmful. The strategist notes that if there are risks to QE, the Fed can continue to buy all the bonds the government needs to finance its debt and deficits; the creation of the reserve does not need to end.
In fact, according to Cecchini, it cannot end. According to him, QE’s success to date in sustaining yields has eliminated the Fed’s room for maneuver. “QE is here to stay,” he says emphatically, pointing out that the last time the Fed pulled back and allowed longer yields to rise, caused stock markets to fall in late 2018. He explains that the Fed must continue the QE in order to monetize Treasury issues that are needed to finance deficits. This, in turn, keeps rates and yields low.
A long-held expectation of some economists watching the level of the national debt rise is that its size, financed by significant growth in the money supply, would trigger inflation. Yet, so far, this is not the case. The following graph, from the Board of Governors of the Federal Reserve, shows the U.S. money supply from 1980 to February 1, 2021.
If, however, the national debt somehow catalyzes a rise in inflation above the Federal Reserve’s 2% “average inflation target” range over time, it will would most likely be fought with the traditional weapon: increasing interest rates. But the higher interest rates are universally assumed to be the kryptonite of the markets, potentially devaluing any instrument that is not at a floating rate.
Buyer Daniel Zwirn, credit markets specialist and chief investment officer of Arena Investors LP, believes national debt will not somehow drive rates up, although he emphasizes that he is not expressing a position of wallet.
Zwirn says the result of today’s growing national debt and low rates could be that the United States, as well as Europe, could possibly look a lot like Japan, a reference to the debt level above 200. % from Japan. He notes that while Japan has low inflation compared to other developed markets, it has also experienced decades of lost growth, with its financial problems spanning this period, instead of being dealt with earlier and with more. vigor.
Cecchini echoes these sentiments. “QE is funding Japan and it’s not killing them – yet.”
Zwirn expects the Fed to keep interest rates low, rather than allowing them to rise in the face of growing national debt, which he believes would be the most appropriate action. “I don’t see a Volcker 2.0,” he said, referring to the policies employed by Paul Volcker, Fed chief of the Carter / Reagan era.
In the late 1970s and early 1980s, Volcker raised the Fed Funds rate to double digits and used money supply limits to fight inflation. William Poole, former chairman and CEO of the Federal Reserve Bank of St. Louis, says Volcker’s policies led to “not one, but two recessions before prices finally stabilized.”
While Japan emerges as a possible bearish scenario, according to the CBO’s February report, US national debt may not reach Japanese-style levels anyway anyway. The CBO predicts that US debt to GDP will remain between 101% and 107% through 2031. However, the CBO also predicts that, unless things change, the US will hit 195% by 2050.
Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC, a decades-long observer of the high yield market and regular contributor to LCD, agrees that, at least for now, national debt will have no direct impact on the markets. or interest. rates. He notes that fighting inflation would be one of the main reasons the Fed hikes rates. But he currently sees nothing on the near-term horizon that will produce more than a temporary spike in inflation that could result from pent-up demand as the strains of the pandemic ease.
According to Fridson, inflation needs – among other accelerators – a high speed of money, a strong job market or a booming economy. He doesn’t see any.
The speed of the US money supply “has fallen off a cliff,” he says (it is, in fact, slower than at any time in the past 60 years, according to the St. Louis Fed. ). Fridson also notes that wage pressure remains limited in the globalized economy. He adds that he sees little risk of the US economy overheating, given that the US workforce is not growing, in part because of the aging population.
Fridson cautions, however, that he’s not saying inflation will never come back. In fact, he assumes that at some point it will – but not in the short term.
While the level of US national debt to many seems harmless at the moment, LaVorgna believes markets may reach a tipping point, at which US debt to GDP is high enough to warrant concern in the markets. He doesn’t know exactly what it is, only that collectively investors can one day believe, as they did with European sovereign debt in the early 2010s, that the national debt has grown too high.
Fridson says much the same thing, noting that “we cannot be satisfied with [the national debt] – there is probably a limit to that “, he adds,” but for the moment it does not cause inflation or problems “.
However, the yield curve is steepening. The spread between 2-year and 30-year U.S. Treasuries fell from 109 basis points on July 31, 2020 to 152 basis points on January 1 to 203 basis points on February 19. classic indication of rising inflation expectations.