- Macro Strategist
United Kingdom, Intermediary
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The recent downgrade of US debt by Fitch raises a number of important questions about the health of the nation’s finances and the policy and market implications. In this brief note, I summarize my views on the US debt situation, including the bond market impact, projections for the US deficit, and key considerations related to the US Federal Reserve’s (Fed’s) plans.
Red flags for the debt level and the deficit — My primary concern on the US debt has to do with the level of debt, which is currently at 123% of GDP. Anything over 100% warrants attention. Plus, the US is running a meaningful fiscal deficit (year to date, it sits at 5% of GDP). Some evidence of this is visible in the behavior of longer-term yields. The yield on the 30-year US Treasury is now above swap rates after being below them in the 1990s, a period when US fiscal deficits were in relatively good shape.
Looking ahead, many deficit projections assume that the Trump tax cuts will expire at the end of 2025, leading to a boost in tax revenues. But this seems optimistic given the country’s current political climate. A simple rule of thumb is that the country’s debt can remain sustainable if interest rates stay below the economy’s nominal growth rate. In the second quarter, US nominal growth was at an annualized rate of about 4.7%, so if rates were to rise above that level, it would bear watching.
Bond yields and the term premium — The recent upward move in bond yields has been driven in part by supply-related factors, including high issuance by the US Treasury, the impact of the Fitch downgrade, and worries about who will buy all these bonds — as Japan eases up on yield curve control and the Fed talks about reducing its Treasury holdings through more quantitative tightening (QT).
The term premium on Treasury bonds (the additional yield investors require as compensation for holding longer-term bonds) should rise over time, given the problematic US fiscal outlook and the unwinding of quantitative easing (QE). The term premium used to fall in a range of 0% – 2% prior to the global financial crisis. It turned negative with the introduction of QE, but I expect it to return to positive territory.
The Fed’s balancing act — Since last year, the Fed has reduced its ownership of domestic securities by US$1 trillion through its QT program. Fed Chair Powell recently indicated the central bank would like to continue QT even when it starts to cut interest rates. No guidance was given, but we could potentially see another US$1 trillion – US$1.5 trillion of QT from here. Cumulatively, that could amount to an increase of 50 bps – 75 bps in longer-term yields. With the Fed wishing to keep optionality on rates alive, the yield curve is steepening, with the long end catching up to the short end as the term premium gets priced back into the curve.
A Fed that wants to stay higher for longer in order to bring down core inflation risks adding to the fiscal pressure and creating instability for the US sovereign market. It’s worth noting that higher real yields also pressure equity valuations and imply lower earnings growth in the future.
Somewhat paradoxically, the Fed is seeing more tightening now, as yields rise, than it did earlier in the year in response to its own tightening efforts. This means the Fed has more room to give ground on short rates if it chooses to. I don’t think we’re there yet, but my base case is that we’ll seen more evenhanded policy from the Fed toward year end (unless something bad happens).
Finally, I’ll be watching the Fed’s Jackson Hole meeting at the end of August for signs of a surprise in its thinking on inflation, QT, and rates. This year’s meeting topic — structural shifts in the global economy — opens the door to considering issues such as the impact of shifting demographics, the energy transition, and supply chains on inflation, growth, and employment.
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