2023-08-28 06:13:00
Fitch’s recent downgrade of the US debt rating has investors worried as the deficit and debt are steadily rising. The downgrade sent 10-year yields up to more than 4%, raising concerns regarding America’s deteriorating financial situation. The problem is that if drastic steps are not taken to reduce spending, this will lead to higher interest rates. The Wall Street Journal reported:
“The United States borrows in its own currency and will never involuntarily default so long as it has a printing press. While higher interest rates push financing needs higher, so does the ability of the U.S. government to change the fiscal course without politically disastrous measures, such as cutting benefits or printing Money overtly, is becoming more limited.
If such drastic steps are not taken, it will almost certainly mean more borrowing. A higher risk-free rate will crowd out private investment and hurt equity value, all other things being equal.”
This certainly seems like a logical conclusion. But the key to the statement is in the last sentence. Many bondholders point out that rates should rise as the deficit increases and more debt is issued.
The theory is that at some point, buyers will need a higher yield to buy more debt from the US. This makes perfect sense given the nature of the bond market’s operation, where the only players are the individual and institutional players in the bond market.
In other words, “all other things being equal,” interest rates should rise in such an environment.
However, all else is not equal in a global economy where government debt yields are controlled by central banks in collusion with governments to maintain economic growth, control inflation, and avoid financial crises.
This is evident in the chart below. Since 2008, central banks around the world have been buyers of global debt.
The balance sheets of global central banks
Why did central banks engage in such a massive bond-buying program? Provide the necessary liquidity to combat deflationary forces of debt and lift global economies out of recession.
As shown, since 1980, every time the economy experienced a recession, the government responded by increasing debt. However, the accumulation of more debt has led to continued declines in inflation, wages, economic growth and interest rates.
Economic Composite vs. Debt vs. Interest Rates
The analysis becomes even clearer when looking at the economic composite index versus the deficit.
GDP deficit and economic compound interest rates
The expectation is thatThis time is differentMore debt and deficits will lead to higher interest rates. However, since 1980, nothing like this has happened.
(The exception was in 2020, when checks were sent to households and the economy shut down, sending inflation soaring.) More importantly, the Fed and global central banks are still reeling from it.
The Fed is still trapped
Before 2020, the Fed wanted to increase inflation. However, following the failed experiment of shutting down the economy and sending checks to households, the Fed now wants to cut.
Ultimately, the Fed will achieve its goal as higher debt levels slow economic growth and slow inflation.
Since 1980, increasing debt levels have been required to establish one’s economic activity. With nearly $5 of debt creating $1 of economic activity, it is unlikely that the ability to promote strong economic growth and inflation will be available.
The debt needed to generate one dollar of economic growth
Even if the “bondholders” were right, and rising debt and deficit levels were to drive up interest rates, central banks would take action to push interest rates artificially low.
At 4% on 10-year Treasury notes, borrowing costs remain relatively low from a historical perspective. However, we continue to see signs of economic decline and negative impacts on the consumer even at this rate.
When the leverage ratio is roughly 5:1 in the economy, interest rates of 5% to 6% are an entirely different matter.
Increase interest payments on government debt, which requires more deficit spending. The housing market will decline. People buy in installments, not homes, and higher interest rates mean higher premiums. Higher interest rates will increase borrowing costs, leading to lower profit margins for companies. There is a negative impact on the huge derivatives market, leading to another possible credit crunch with the collapse of interest rate derivatives. As rates increase, variable interest payments on credit cards also go up. This will lead to a shrinkage of disposable income and a rise in defaults. There is a negative impact on banks as higher rates of default on large debt levels erode capital. Rising interest rates will negatively affect retirement plans that are already underfunded, creating insecurity regarding meeting future obligations.
I might say more, but you get the idea.
The Federal Reserve will get involved
The issue of rising borrowing costs is spreading through the entire financial ecosystem like a virus. This is why the Fed and the government push interest rates lower through monetary and fiscal policies. This is especially true given that interest on existing debt absorbs roughly 1/5 of the collected tax revenue.
The biggest problem with the “interest rates must rise” thesis is the inability of the economy to maintain higher interest rates due to increasing debt issuance and rising deficits. The Congressional Budget Office recently updated its debt projections for the next 30 years.
The chart below shows samples for analysis using the trend of debt growth, but also takes into account the Fed’s need to monetize approximately 30% of this issue.
Projected US government debt levels
At the current rate of growth, the federal debt burden will rise from $32 trillion to nearly $140 trillion by 2050. At the same time, assuming that the Fed continues to monetize 30% of debt issues، Its balance sheet will swell to more than $40 trillion.
Let this sink in for a minute.
And what should not surprise you is that unproductive debt does not create economic growth. Since 1977, the 10-year average GDP growth rate has steadily declined as debt has increased.
Thus, using the historical growth trend of GDP, the increase in debt will lead to slower rates of economic growth in the future.
Debt levels and economic growth forecasts
Conclusion
Therefore, as debt and deficits increase, central banks will have to cut interest rates to keep borrowing costs low to sustain weak economic growth rates. The problem is assuming that interest rates should triple:
All interest rates are relative. The assumption that US interest rates are regarding to rise is likely to be wrong. Higher yields on US debt are attracting capital inflows from low-yielding countries into negative territory, which pushes down interest rates in the US. Given the current pressure from central banks around the world to suppress interest rates to keep the nascent economic growth going, reaching zero yield on US debt may be realistic. Inflated the next budget deficit. Given Washington’s lack of fiscal policy discipline and its promises of continued largesse, the budget deficit is expected to swell to more than $2 trillion in the coming years. This will require more government bond issuance to fund future expenditures, which will swell during the next recession as tax revenues fall. Central banks will continue to buy bonds to maintain the status quo, but they will become more aggressive during the next recession. The next quantitative easing program by the Fed to offset the upcoming economic downturn is likely to reach $4 trillion or more, pushing the 10-year bond yield towards zero.
If you need a road map for how this can end up being lower, look to Japan.
Policy analyst Michelle Walker described this kind of problem in her 2016 book The Gray Rhino, which was an English-language bestseller in China. In contrast to the sudden crisis dubbed the “black swan”، The gray rhino represents a potential event that carries many warnings and clues that are ignored until it is too late.
Add debt to that list.
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#gray #rhinoceros #ravage #economy. #solution
