As you have seen, I have been writing extensively about the prospectivity of Fixed Income for some time. Today I’ll provide further evidence to support this view.

 

While the U.S. is facing a mountain of debt. the sky is not falling, despite media proclamations.

 

With financial markets taking the U.S.’s deteriorating fiscal position in stride, underweighting fixed income in portfolio is likely to lead to subpar returns.

 

Over the past year the U.S. fiscal position has undeniably deteriorated: debt-to-GDP has moved higher, debt servicing costs increased, and the Congressional Budget Office’s projected fiscal balances shifted deeper into deficits. In short, the U.S. has more debt, more expensive debt, and is adding to the burden at a faster pace. Rating agencies have taken note, with fiscal policy and government dysfunction causing the U.S. to lose its AAA status.

 

At least for now, however, markets are shrugging off the news.

 

As of Dec. 6, equity and bond markets were higher on the year, and the dollar had appreciated against trading partner currencies—a strange result if investors were worried about rising U.S. government credit risk. Expect this behavior to continue and for asset prices to ignore U.S. debt levels. Longer-term, investment plans built around any potential U.S. debt crisis are likely to underperform a balanced portfolio by significant amounts.

 

What gets (mis)measured gets (mis)managed?

 

The U.S. federal government has an astonishing $33 trillion in debt. Even after eliminating borrowing between various government agencies and adjusting for the growth of the economy, the only comparable debt in modern U.S. history was after World War II. But that particular measurement—debt owed directly by the U.S. government to investors—is not the only measure of financial leverage in the overall economy. Households, banks, local governments, and non-financial corporations all rely on borrowed money to varying extents.

 

In these other areas, the U.S. doesn’t look so bad. This borrowing by lower-level entities has two impacts on a nation’s financial balance. One is the direct impact.

 

Borrowing by households, for instance, tends to reduce future consumption as resources are diverted to debt servicing. At a macro level, there is little difference if GDP growth is under pressure from debt-laden governments or over-leveraged households—the economic risk and pain are substantially the same.

 

The other concern is that in a crisis this non-government debt will ultimately have to be backed by the entire nation and, as such, should be viewed as contingent obligations of the central government. The typical example, is the global financial crisis, when bank and household mortgage debt was effectively backstopped by an alphabet soup of government programs.

 

While a repeat of 2008 is highly unlikely, it’s important to properly compare debt data between countries:

 

• Germany’s federal debt is extremely low by international standards, but its banking system liabilities relative to GDP nearly triples that of the U.S.
• China is a net creditor at the national level, but the picture shifts when including substantial municipal and local government debt—a factor in Moody’s recent decision to shift to a negative outlook.
• Canada’s federal debt is low, but households have built up a substantial debt burden— nearly 50 % larger than the U.S. numbers adjusted for GDP.

 

Ignoring these liabilities and focusing only on central government debt ignores the similarities in the day-to-day impact of leverage on the broader economy. Furthermore it also ignores the potential for a rapid and unforeseen increase in national debt in a crisis.

 

Financial crises tend to arise when there is a rapid, unforeseen event. Problems with a long lead time tend to get resolved with adjustments instead of shocks. Investors hope to see a gradual shift toward fiscal balance (the cost of debt funding erodes the value of tax cuts and higher spending). Even though a gradual adjustment is likely, don’t expect it to be anytime soon.

 

Not many people really care about fixing the problem. Surveys of even self-described fiscal hawks show that when it comes to ranking policy choices, debt reduction falls below tax cuts and identifiable spending priorities. In short, everyone wants debt reduction if someone else makes the sacrifice. That’s a political non-starter.

 

The principal problem with pushing for lower debt levels is the near-total lack of evidence on what problems arise for countries that issue bonds in their own currency. Japan shows us that debt-to-GDP over 200 % can co-exist with low interest rates and low perceived default risk. Beyond that, we then move into unknown territory.

 

It is reasonable to argue that the U.S. is on the cusp of losing investor confidence because of its large stock of outstanding debt. For now, bond financing markets are one clear indicator that there is no imminent concern.

 

Most bonds are financed using repurchase agreements, more commonly known as repos (a short-term loan with bonds offered as collateral). Most repo loans are repaid within a day, meaning that lenders typically risk millions of dollars of cash to earn mere hundreds of dollars in interest. This tell us that the lender is more than comfortable with the credit quality of the U.S. Government Debt.

 

U.S. Treasuries are the preferred asset type for most lenders. Borrowers with Treasury collateral, broadly speaking, can borrow more and pay less than investors who offer other bonds as security.

 

For at least 40 years, we have been hearing how U.S. fiscal imbalances are unsustainable. For all that time those imbalances have been sustained, the U.S. economy has grown, and financial markets have generated positive returns. Given this outcome, it is somewhat surprising that the press continues to attach so much importance to U.S. debt levels.

 

People generally focus on strategies that have worked. The call for a U.S. debt disaster has been an unmitigated failure for decades. History is likely to continue and that positioning for a U.S. debt crisis is likely to lead to subpar returns.

 

If you have any questions or comments, please feel free to let me know.