Are U.S. Debt to GDP Concerns Misplaced?
November 6, 2023
In recent months, market commentators have zeroed in on “unsustainable U.S. fiscal policy” as the source of bond market woes. Even the normally boring quarterly announcement of Treasury borrowing targets is getting as much airtime as the Federal Reserve meeting. The fear is that higher U.S. debt levels, will cause investors to demand higher rates, creating more equity-like losses in the bond market.
All else equal, higher debt levels equal higher defaults, which require higher rates as compensation for risk. It’s why emerging market and junk bond issuers pay higher yields. But all is not equal when it comes to developed market government bonds. In fact, empirical evidence suggests the opposite: higher debt leads to lower yields. Since 1970, increases in U.S. and Japan government deficits correlate with lower borrowing costs, not higher rates. Real bond yields fell in the U.S. ever since budget deficits started growing in the early 2000s. The same is true in Japan since the 1990s.
What explains this seeming contradiction to mainstream theory? Chronic oversaving, the crowding out effect and central bank independence all play a role. Most G7 countries had a common problem for the last few decades: excess savings in the private sector. Instead of spending and investing, the private sector saved, resulting in slower growth. This forced governments to issue debt and increase spending to keep economic growth going. Higher government yields decrease government spend and crowd out private sector borrowing, creating a self-reinforcing slowdown loop. Markets price in the slowdown by bidding down long-term rates and “independent” central banks stimulate the economy and keep debt service costs low by lowering short-term rates. The net effect is more debt at lower rates.
The key investment question therefore is not whether the U.S. has too much debt, but whether the U.S. is switching from an over-saving / under-investing problem of the previous 20+ years to an under-saving / over-investing one of the last 2. We don’t believe that to be the case. This year’s formidable growth came from a combination of government spending and prior savings drawdown, i.e. under-saving. It is unlikely to repeat going forward. The economy will likely slow, forcing the private sector to tighten belts and the Federal Reserve to lower rates. Rather than fearing debt to GDP levels, investors may be better served by positioning for slower growth and lower rates instead.
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