With another funding deadline looming, the Democrats and Republicans have reached a $1.66trn deal on US spending. This averts another potentially disruptive shut-down. Nevertheless, the level of US government debt remains a key risk to the benign outlook for US treasuries in the year ahead.
The agreement comes just in the nick of time, with funding for a number of government departments set to run out on 19 January. Any deal still needs to be passed by both houses, and is separate from the billions of dollars in aid requested for Ukraine and Israel. It does nothing to avert concerns that US debt is unsustainably high, and the government will continue to lurch from crisis to crisis until it is addressed.
Record debt
The US national debt is currently sitting at nearly $33trn, up almost 90% since the start of the pandemic. It is at nearly 100% of GDP. The Committee for Economic Development, the public policy centre of think-tank the Conference Board, says a responsible debt to GDP ratio for a country the size of the US would be around 70%, but admits it could take 20 to 30 years of a sustained effort to draw debt-to-GDP to these levels.
It adds: “High levels of debt can diminish economic growth. Rising debt service costs will consume the discretionary budget, crowding out all other priorities; cause higher interest rates and borrowing costs for public and private sectors; weaken investment; and erode the standard of living.”
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For its part, the Federal Reserve Chair Jerome Powell says debt is not a problem today, but adds: “The path we’re on is unsustainable, and we’ll have to get off that path sooner rather than later.” The Penn Wharton Budget Model suggests that US debt could reach 175%-200% of GDP by 2040.
It adds: “The United States has about 20 years for corrective action after which no amount of future tax increases or spending cuts could avoid the government defaulting on its debt whether explicitly or implicitly (i.e., debt monetization producing significant inflation). Unlike technical defaults where payments are merely delayed, this default would be much larger and would reverberate across the US and world economies.”
Yet there appears to be little political incentive to deal with the debt burden, and it has risen under every administration since 1990. Economic theory suggests that debt should be raised during periods of emergency to prevent burdening the population with higher taxes at a time of economic difficulty, but it has risen during all types of economic environment.
Rising yields?
To date, the US has been able to borrow largely free of consequences. The dollar has remained strong, investors have not demanded a higher price to lend and there have been willing buyers. However, as debt levels rise, all these elements come under threat. It is possible that China, for example, becomes less inclined to buy US debt, long-term yields reset higher and it exerts a squeeze on economic growth.
In its latest Insights, JP Morgan Asset Management focuses on these risks: “While infrastructure spending programmes will support economic activity for some time, governments will have to turn their attention to how they will balance the books at some point. A 6% budget deficit in the US at a time when unemployment is near a record low is simply not sustainable, particularly given the central banks are no longer buying government debt.”
Russ Mould, investment director at AJ Bell, says debt at these levels may make the Federal Reserve more inclined to cut rates: “America’s latest annual fiscal deficit was $1.7trn in the year to September 2023, the third-worst number on record, and the annualised interest bill has hit $1trn, or 20% of tax income. America cannot afford to keep interest rates where they are for long and there is a risk that the Fed has to cut rates to keep the burden manageable and take risks with inflation.”
He says that this could be why gold and even Bitcoin have been rising sharply. Investors have been looking for alternative sources of safety, away from the US dollar and US treasuries. While rate cuts are being priced in because inflation is cooling, they could equally arise because policymakers realise debt is a problem and interest costs could squeeze growth.
Dollar wobbles
High debt levels are also likely to have an impact on the dollar. Anujeet Sareen, portfolio manager at Brandywine Global, is anticipating a deceleration in US fiscal support in 2024: “While some policies will continue to offer some further support to certain sectors of the economy, we expect fiscal policy will shift to a modest overall headwind next year. Additional fiscal policy support from Washington is unlikely given a split Congress in an election year…The sustainability of US government debt dynamics is a longer-term headwind for the US dollar.”
Moody’s lowered its outlook for the US to “negative” from “stable” in November, citing large fiscal deficits and a decline in debt affordability. Fitch had already downgraded US debt (from AAA to AA+) in August for the same reasons. In general, markets have greeted these downgrades with equanimity, but there may be a stronger response if debt continues to increase.
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A final question is whether there is a risk that buyers will dry up for US debt, meaning treasuries will need to offer higher yields to tempt investors. Around 23% of overall debt is held by foreign and international investors – equivalent to around $7.6trn.
Within these, Japan and Mainland China currently hold the greatest portions, with China holding $868.9bn. On balance, any reluctance from Chinese buyers is only likely to make a marginal difference for the US treasury market, but it remains an outside risk. More important could be the actions of the Federal Reserve, which currently holds a greater share of the treasury market and has been trying to unwind its position.
The US has averted a crisis on its debt, but needs to address it over the long term in order to avoid a crisis. The current febrile political environment makes that less likely, with the Democrats inclined to spend and the Republicans inclined to cut taxes, and neither side inclined to level with the US population about the consequences.
