By Andrew Tanzer, CFA
- US total public debt is poised to surpass $20 trillion.
- Over the past 20 years, this figure has quadrupled, far outstripping the rate of growth of the US economy.
- Due to prevailing low interest rates, the cost of maintaining even a significantly higher debt has actually fallen relative to total federal spending over this period.
- Rising rates could spark a “negative feedback loop,” by increasing the cost of US debt to the government, thereby shaking the confidence of investors that the debt level is sustainable and causing them to sell their US bonds, further driving up rates.
- This scenario could cause higher volatility in bond markets.
In recent weeks, the Dow’s 20,000 milestone has captured news headlines and investors’ attention. We believe investors should also be paying attention to another, less publicized, “20” milestone. Any day now, the United States’ total public debt is poised to surpass $20 trillion. Apart from representing a truly vast number, what does this level of public debt represent, and what are some possible implications for investors?
Before digging into this debt mountain in greater detail, let’s clarify what the number we’re talking about represents. The $20 trillion gross national debt can be divided into two components: debt held by the public, about $14.4 trillion, nearly half of which is in the hands of foreign investors including the Chinese and Japanese governments; and $5.6 trillion of “intragovernmental debt” held in US government accounts for beneficiaries such as the Social Security Trust Fund (half of the entire amount), military and civil service retirement funds, and the like.
In and of itself, an absolute number like $20 trillion doesn’t necessarily mean much, but when you consider its growth and cost of servicing in the context of the overall economy and budget reality it takes on more meaning. For example, over the past 20 years the debt figure quadrupled from $5 trillion to the current level of $20 trillion (see Exhibit 1). Since the rate at which debt compounded far outstripped the expansion of the economy, the ratio of US debt to GDP (Exhibit 2) during the same 20-year period rose from 65% of GDP to 106%, with all of that increase occuring in the aftermath of the 2008 financial crisis.
Equally important is the cost of maintaining that debt. While homebuyers can take out fixed-rate mortgages, the cost for the US government to maintain its debt is highly variable. As interest rates shift and US Treasuries mature, new bonds are issued at current interest rates. Over the past two decades, the US has been in an environment of generally falling rates, with the effective cost of the debt declining from 6.5% in 1997 to 2.2% last year, according to US Treasury statistics. Thus, over a timeframe when the outstanding stock of debt quadrupled, total interest expense increased only modestly, from about $356 billion in 1997 to roughly $432 billion in 2016 (see Exhibit 3). As a result, the cost of maintaining even a significantly higher debt has actually fallen relative to total federal spending (see Exhibit 4), from 21% to just 11%.
That Was Then
But here is where things could get sticky. The days of a low interest-rate environment, with 10-year US Treasury bonds yielding 2% or less and the government able to service $20 trillion of debt with a relatively manageable portion of the total budget may soon be in the past. Interest rates are rising (the yield on 10-year Treasuries rose by 70 basis points to 2.47% in the year to February 16, 2017), and the market’s expectation for the Trump Presidency is for higher economic growth, inflation and interest rates, which could dramatically change the current equilibrium.
We don’t make forecasts, but here’s one plausible scenario painted by the Congressional Budget Office (CBO), which considers just publicly held debt ($14.4 trillion of the current $20 trillion gross national debt). The CBO projects that debt held by the public will increase from $15 trillion at the end of 2017 to $25 trillion by 2027, largely due to swelling budget deficits. This would raise the public debt/GDP ratio from 77% to 89%, which the CBO notes would be the highest level since 1947 and more than twice the average over the past five decades in relation to GDP.
For its ten-year projection, the CBO assumes economic growth and inflation rates of about 2% and a rise in interest rates on the 10-year Treasury from 2.1% in the fourth quarter of 2016 to 3.6% in the latter part of the next decade. It estimates that the combination of rising interest rates and growing federal debt held by the public will cause government interest payments on that debt to nearly triple in nominal terms and almost double relative to GDP. The CBO thinks rising interest payments will lead to a drop in government discretionary spending from 6.3% of GDP in 2017 to 5.3% by 2027, the smallest ratio since comparable data was kept from 1962.
The CBO scenario projection doesn’t need to be exactly right to observe the substantial risk of much higher debt-servicing costs in the federal budget. A one-percentage point rise in rates now implies a $200 billion annual increase in interest payments, and more in future years as the stock of outstanding debt expands from $20 trillion. The question of how sustainable this level of debt is for the United States is complicated somewhat by the use of the US dollar as the world’s reserve currency, and by the extensive and intensive use of US Treasuries as a highly liquid, low-risk investment by banks, funds, and governments around the world. There are many possible scenarios, but one is the possibilty of a “negative feedback loop,” wherein rising interest rates increase the cost of US debt to the government, shaking the confidence of investors that the debt level is sustainable and causing them to sell their US bonds, further driving up rates.
Conclusion
We do not make any specific predictions, but it does seem prudent for investors to be prepared for potentially higher volatility in bond markets, stemming from the strong possibility of the confluence of rising rates, higher US government debt levels, and much higher annual interest expenses in the federal budget, which could change investors’ perception of Treasuries and risk. For our elected officials, burgeoning interest payments would require some tough decisions on government spending programs.
