A clear winner from the Fed’s 25 basis point rate cut was the U.S. Treasury, which can roll over maturing debt at lower costs.
Lower rates however, are unlikely to make the country’s fiscal policy sustainable. Even with the Fed’s assistance, U.S. borrowing concerns remain.
Today we’ll examine other options available to the U.S., as well as their market impact in the face of growing federal debt.
Lower financing costs can help slow debt buildup, but they are unlikely to make the country’s fiscal policy sustainable. It’s increasingly clear that the U.S. will resort to several of the tried-and-true tactics of overi-ndebted nations, such as currency devaluation and bond market interventions.
While the chance of a U.S. default is virtually non-existent, there will be implications for multiple asset classes as the U.S. confronts its unwillingness to tax companies and citizens at higher levels.
The easiest way to deal with debt maturities is to repay them with borrowed money. This is known as “rolling over.” There’s nothing inherently risky with the maneuver. Many companies—including highly rated, cash-rich enterprises—regularly pay off maturing bonds with new debt.
For countries it’s largely the same.
No one would argue that zero debt is the only sound way to run an economy. The question is how much debt the economy can reasonably carry and roll forward on an ongoing basis. Unfortunately, there is no sound empirical or theoretical answer to that question. 60 % of GDP—or roughly half the current U.S. debt burden—is a ballpark, if likely conservative, number to use.
Beyond that, there are other ways the U.S. can reduce its levels of borrowing:
- Economic Growth: If the growth rate of the U.S. economy exceeds the average interest rate paid on the debt—and the government keeps the budget roughly balanced before interest costs—then the debt-to-GDP ratio can drop over time. Growth doesn’t reduce debt as much as alleviate the harms of it.
- Fiscal surpluses: The fastest way to reduce debt is to manage the federal budget in a prudent manner: raise taxes and lower spending. The economic problem with this approach is that it’s contractionary—it tends to slow economic growth by using today’s resources to pay for past expenditure.
In reality taxes are unpopular and government checks are not. While fiscal discipline may sound nice as an election promise, in practice it’s not effective.
Countries can print money - individuals and businesses can’t.
As part of implementing its new 4.00 % to 4.25 % overnight interest target, the Fed will offer cheaper funding to certain private entities to purchase government securities. This will set a lower effective ceiling on what short-term debt can cost the U.S. Longer-maturity government debt (maturing in 10 years or more) is less directly influenced by the Fed.
With the higher volatility of these bond prices and economic uncertainty, it’s a riskier for private investors to rely on the Fed’s short-term funding to buy longer bonds.
This is where the Treasury can act.
In addition to increasing the pace of buybacks of longer-maturity debt, the Treasury has increasingly relied on loans maturing in a year or less to fund its operations.
This will however, bring higher risk to U.S. government finances as it provides less visibility into funding costs. It also increases pressure on the Fed to keep short-term rates low as a way of avoiding the negative economic consequences.
The Treasury —with or without the Fed—has other levers it can pull.
Capital controls which require additional government bond purchases from regulated institutions. While unlikely, it does remain in its back pocket.
The final way is through inflation.
Economists traditionally talk about inflation through the lens of consumer prices, but there’s a strong case to be made that government wastefulness can also show up in asset prices. Lower-income households tend to spend a greater percentage of increased earnings, while higher-income households tend to invest more of any newfound cash.
In situations where government deficits are improving the finances of upper-income households, one would expect increased demand for investment assets, such as gold, stocks, and homes.
It’s no coincidence that these assets are at or near their all-time highs.
The other way of thinking about asset price inflation is through currency. Artificially low rates, policy volatility, and concerns on debt levels have played a role. The U.S. dollar’s 10 % year-to-date depreciation vs. other major currencies is proof of this.
For investments measured in dollars, the shorter yardstick of value makes it easier to have high nominal returns.
It’s no surprise that politicians will choose the path of least resistance and greatest popularity. For holders of U.S. debt, that means a likely future of artificially low rates, relative underperformance versus other asset classes.
As always, please let me know if you have any questions or comments.