“There is always a disposition in people’s minds to think the existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which make it unlike its predecessors and give assurance of permanency. The fact pertaining to all conditions is that they will change.” – Charles Dow, 1900
Treasuries continue to tell, what I think, is the real story of the economy. Most people who watch the market tend to minimize the risks involved in accumulating nearly $30 trillion in debt because 1) large-caps are still near record highs, so investors have mostly felt little pain and 2) record low interest rates have made this debt relatively serviceable for the time being. We haven’t heard much about the coming debt ceiling expiration at the end of this month as rising COVID threats and even infrastructure to a lesser degree capture headlines. Make no mistake about it though. You are going to hear a lot more about it soon and that is probably going to put pressure on Treasury rates to go even lower.
It is discouraging that both sides of the political aisle appear to be dug in for now, raising the risk that this situation could turn ugly quickly. The fact that the terms “extraordinary measures” and “technical default” and “running down cash balances” and “wiggle room” are showing up more and more in the financial media indicates that a credit downgrade and the consequences of hitting the debt ceiling without a resolution are very real and should not be ignored. Risk assets reacted quickly and negatively in 2011 when this happened the last time. It is possible it could happen again.
If you have not already, it is time to start taking a longer-term view of the financial markets and the economy. I understand that the Dow, the S&P 500 and Nasdaq 100 are at all-time highs and equity investors still maintain a healthy amount of bullishness, but it’s time to start paying attention to what the economic fundamentals are telling us. Wall Street enthusiasts always like to say, “this time is different”, but mean reversion almost always wins it in the end.
I have been griping about the possibility of a government debt downgrade for weeks now with the current suspension of the debt ceiling set to expire at the end of this month acting as the catalyst. While most people agree that an actual debt default is unlikely (even if the debt ceiling is not extended, the government still has cash to work with in the meantime and would almost certainly come to a resolution before a “catastrophic”, as Janet Yellen would put it, outcome were to occur), the odds of a rating downgrade by one of the major credit agencies is much more likely.
In fact, the rating agency Fitch has had one on its radar for nearly a year now.
Back in 2011, the three major agencies - S&P, Moody’s, and Fitch - placed a negative outlook on Treasury debt with S&P going all the way as to cutting the rating from AAA to AA+. By 2014, they all returned their outlooks to “stable” as the immediate debt ceiling crisis passed.
Fitch was the only one of the three to flip its outlook back to “negative” during the COVID pandemic. It cited a deterioration in U.S. public finances as well as the lack of any firm plan to address the growing debt - a situation that has only worsened as the U.S. debt closes in on the $30 trillion mark with additional large spending packages, including infrastructure, still on the table.
To understand how the debt ceiling fight could lead to a potential rating downgrade and a dollar devaluation, it is helpful to look at a step-by-step for how this could potentially play out. Here is what we know today.
The federal government will soon have $30 trillion in total debt on its books. The average interest rate on this debt as of the end of 2020 was about 1.7%. That means the government can be expected to pay just over $0.5 trillion in 2021 alone servicing existing debt.
The government takes in around $3.5 trillion in tax revenue annually, so $1 of every $7 taken in already goes towards interest payments. The Fed plans on leaving interest rates near zero until at least 2023. Even though the latest dot plot report suggested pulling the rate hike calendar forward, several Fed governors have worked to calm fears of higher rates by reinforcing a more dovish rhetoric. Tapering asset purchases could come much sooner, but there is no firm timeline yet.
The 10-year Treasury yield is sitting at just under 1.4%. The current inflation rate is 5%, but it is expected to come back down to some degree as low base effects and supply chain issues wear off.
The government used to issue a more balanced mix of shorter-term and longer-term Treasuries to raise funds. That mix has turned progressively more short-term over the years to help minimize borrowing costs. From a financial standpoint, that is a good thing, but it makes U.S. debt more vulnerable to rising interest rates since low-rate debt will roll off the books faster.
That is also reflected in the average interest rate paid on U.S. Treasuries.
The average rate got up to around 5% just before the financial crisis but has been drifting lower pretty much ever since. The focus on Treasury bill borrowing to fund various stimulus packages has pushed the average borrowing rate down to around 1.7%. If rates rise and the average interest rate moves back to its pre-pandemic level of 2.5%, that adds another $240 billion in interest expense. Suddenly, that $1 of every $7 in tax revenue going towards interest expense turns into $1 of every $5.
Now, compare that chart to the path of the 10-year yield over the past two decades.
Not surprisingly, the two look similar - rates slowly rising in the mid-2000s and again from 2017-2019. The problem is that the average interest rate paid curve trails the 10-year yield curve by about two years. You can see that the 80 basis point rise in Treasury yields over the past year isn’t showing up in the average that the government is paying for borrowing. In other words, borrowing costs for the government may be getting ready to go up again just when it needs to focus on debt solutions. Again, a lot of that borrowing is being done at short-term rates, so there may not be a significant impact, but still.
You can also see why the government needs inflation to be not permanent and interest rates to remain as low as possible for a while. With debt spiraling, no good solution in place to solve the problem and debt balances soon to become unmanageable, there might be no good way to avoid an adverse outcome. It is just a matter of which one the powers-that-be choose.
Here is what I see as some of the most likely paths the government could take here and what their potential impacts might be.
Solution: Refinance debt to lock in low long-term rates
Potential Outcome: Create longer-term financial stability, but short-term interest expense rises.
With the government always focusing on the here and now, this choice seems unlikely. On one hand, it makes a lot of sense long-term because you are essentially locking in a 1-2% borrowing rate for the next 10-30 years. On the other hand, that would also mean the government paying 1-2% more than they would have to if they just would have stuck to issuing near-zero rate T-bills. Plus, it would be paying that interest rate for decades instead of just the next year or less.
This move would help alleviate longer-term pressures once interest rates begin rising again, but it creates more pressure in the short-term since existing debt would be more expensive to service.
Solution: The Fed raises interest rates sooner than 2023.
Potential Outcome: It improves real yields, and the dollar rises, but it potentially swings the economy back into recession and hurts risk asset prices.
A cynic like me would argue that the Fed cares about the financial markets first, the economy second and the dollar last. Plus, there is no guarantee that the government or the Fed even wants a stronger dollar here. It is easy to make the argument that the current state of the economy no longer warrants keeping the Fed Funds rate at zero, but the Fed does not want to take the chance at rocking the boat. It wants to be very careful at telegraphing its moves, so the market is not caught off guard. 2018 should be a reminder that the Fed would be quick to reverse course if things start to go sideways.
Solution: Keep interest rates low and hope that inflation does not remain hot.
Potential Outcome: The Fed can let the deficit run if it can borrow at near-zero rates. Equities could continue to do well, but the dollar sinks.
This seems to be the most likely course of action - roll the dice and hope for the best. Near-zero interest rates help to keep a floor under asset prices, which is a goal of the Fed whether they explicitly state it or not. The biggest risk is that inflation is here to stay longer than expected. Even if inflation doesn’t stay at 5%, but remains at 3% or so, real yields remain historically low, and the Fed would likely be forced to raise rates quickly to prevent the economy from overheating. This would be the scenario where both equities and the dollar likely fall, and the Fed loses its grip on the situation. The phrase “soft landing” would be the ideal outcome, but who knows if the Fed can pull it off.
Solution: Raise the corporate tax rate.
Potential Outcome: It would help the debt problem and the dollar, but it would come at the expense of GDP growth and equity prices most likely.
Raising the corporate tax rate is probably the easiest way to increase tax revenues without running the risk of angering voters. Taking away any political angles, the corporate tax cut enacted under did help spur economic growth in the short-term, so its reversal would likely result in the opposite effect. An increase in tax revenues, however, would need to come without a corresponding increase in spending though. That is something that the government has, so far, shown no interest in.
There are almost no good solutions here. Whichever path the government chooses to take, it is almost certain either stock prices, the U.S. economy, or the dollar. That is the consequence of focusing on short-term gain at the expense of the long-term. If there had been a focus on both short- and long-term solutions, it could have helped minimize the risk of a more painful tail risk event.
Instead, the government has insisted on historically loose financial conditions and unlimited liquidity to inflate the bubble to its breaking point. Now, it is effectively backed itself into a corner where it’s forced to try to choose the “least bad” option.
If the ratings agencies are viewing the current environment in the same way I am, I think they at least have to consider changing their outlook to “negative” or even cutting the rating altogether.
As a supplement to this writing, see what I wrote in January of this year. CLICK HERE
Feel free to use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Email: firstname.lastname@example.org | ivoryhill.com
8400 Normandale Lake Blvd, Bloomington, MN 55437
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