If the US were a company, would you invest?
Like corporations, governments have revenues and expenses and can also borrow money by issuing debt, i.e. Treasuries in the case of the US.
95% of the US’ revenue is tax-derived, including corporate and individual income, payroll, and other taxes. The remaining 5% comes from estate taxes, penalties, customs, Fed earnings and other. These taxes are expected to cover all government expenses, including defense, infrastructure, and interest payments on debt.
Also, like a business, spending more than you make leads to a deficit.
At the time of writing US national debt sat at $33.7 trillion, half a trillion of which was added during the previous fortnight. To put that in perspective, it is an amount equivalent to the GDP of Norway or Sweden.
Interest payments have risen from $600 billion a year ago to $1 trillion now. To put this in perspective, the US now pays more money in interest expenses than it does its entire military.
Hirschmann Capital noted in 2020 that within the past 120 years, any country which has sovereign debt to GDP ratio of 130% or higher had a 98% chance of defaulting on its debt. The US hit 130% in 2020, see below:
Congressional Budget Office (CBO) Projected Debt to GDP (https://www.cbo.gov/publication/57038)
There are three common options for governments attempting to reduce their deficit: cut expenses, stimulate GDP, or raise taxes. The easiest short-term path for covering rising expenses, however, especially with election cycles looming, is to issue more debt.
The Problem in Issuing More Debt: The Treasury and Reverse Repo Market
As with any comparison to a company, the lending dynamic is such that as debt levels rise, lenders become wary, demanding higher rates for their investments.
At the time of writing attention was on the Treasury more than the Fed due to recent activity in the bond market. The US just conducted a horrendous auction for their longer dated Treasuries, trying to borrow $24 billion (which is just 5 days of US fiscal deficit…!) by offering 30-year debt. The rates had to be dramatically increased just to get enough buyers, as depicted below:
Even with this increase in rates, primary dealers had to purchase 25% of the debt. China, Japan, Saudi Arabia, and Russia now no longer appear to be purchasing the debt and most countries holding US debt outside of the US itself appear to be selling. Moody’s has changed its outlook on the US from stable to negative. Any further missteps and the US will lose its AAA rating, which in turn increases the cost of borrowing from a credit perspective.
In terms of the rest of the debt issuance, the Treasury announced they would look at borrowing most of their debt at the short end of the curve (T-Bills and short-term notes). This was to draw money from the large amount of liquidity in the reverse repo facility built up due to Covid-related money printing. This facility has been drained of $1 trillion in just 6 months (see figure 3 below):
Government borrowing has accelerated so rapidly that short-term yields are attractive enough for cash to migrate from the risk-free Fed reverse repo market and be used for to lend to the US. However, the more the US government borrows at the short end, the more cash will leave this reverse repo market, and once that is empty the US government will need another source to tap for borrowing.
At the current rate, this may take only 6 months to drain, and government borrowing is accelerating. One consequence is predictable here: higher rates!
The Debt Spiral
In a recent interview with CNBC, billionaire investor Paul Tudor Jones described the U.S. fiscal situation as follows:
“You get in this vicious circle, where higher interest rates cause higher funding costs, cause higher debt issuance, which cause further bond liquidation, which cause higher rates, which put us in an untenable fiscal position.”
The below attempts to illustrate this spiral where increases in debt issuance only lead to increases in more unsustainable debt.
Referencing image by Guilbert Gates of the New York Times (https://archive.nytimes.com/www.nytimes.com/interactive/2011/08/14/business/markets-debt-spiral.html?src=tp)
Jones also mentioned that the US needs to raise taxes and cut spending to contain the fiscal situation. This may be unlikely during today’s political environment as Republicans are likely to oppose tax increases and Democrats are likely to oppose cuts to entitlements. As for military spending, this is unlikely to be cut with the global geopolitical situation. So, what may likely to be left is to let inflation run high above target levels and keep real yields negative.
As highlighted above, high interest rates are increasing the fiscal debt, but the balance sheet is also reducing, which is causing the reverse repo market to drain. Bank Cash levels as a % of total assets are also back to pre-2008 limits.
Larger banks can still draw down, but as you can see from the below, there is not much room left here:
Large deficits and money supply growth may cause larger impacts than previously seen. Though technology will continue to have a deflationary effect in the corporate world, the world of manufacturing energy and commodities alongside deglobalisation and decentralisation of supply chains is likely to contribute to an inflationary backdrop.
Holding hard assets may be popular with a potential decade of currency debasement and inflation peaks and troughs.
As we witness the interplay of fiscal policies, market dynamics, and geopolitical tensions, it becomes increasingly clear that staying informed and agile is essential for any risk manager.
The debt spiral has serious implications for financial risk management in 2024
Financial institutions need a clear understanding of the nuances of the debt spiral. This is no longer a matter of intellectual curiosity, but rather an essential skill for navigating the ever-evolving landscape of financial markets. Incorporating systemic factors into sell side platforms and stress test calculations is essential.
This integration of government debt dynamics into risk management frameworks underscores the importance of a holistic approach to financial risk management. It is a reminder that in today’s interconnected financial world, the ripples from government balance sheets can quickly turn into waves, affecting markets and investment strategies globally. For risk managers, this represents an additional layer of complexity but also an opportunity to demonstrate the value of thorough and forward-thinking risk analysis.
Risk professionals must now adopt a multifaceted approach that includes not only traditional financial metrics but also in-depth understanding of fiscal policy and its broader implications. This means staying abreast of global economic trends, understanding the interdependencies of various markets, and recognizing the potential for sudden shifts in investor sentiment.
In turn, there is a growing need for developing sophisticated sell side platforms that can capture the nuances of government debt dynamics. These models should be able to simulate various scenarios, including extreme market conditions, to help firms prepare for a range of outcomes. The journey ahead for risk managers and financial professionals is undoubtedly challenging, but it also presents unique opportunities to redefine the role of risk management in a rapidly evolving financial world.