US Debt Trap - Signed, Sealed and Delivered?
Updated: Apr 2, 2020
SUMMARY :
A simple calculation can conservatively project that US sovereign debt to GDP will rise to at least 150% by 2030.
That would surely cement the US in a debt trap, limiting any rise in future interest rates so as to not amplify budget deficits.
The 2014 "Japanification of the Eurozone" trend brought a convergence of the Eur interest rate curve to the Japanese one as expectations of higher forward European rates got crushed.
Forward interest rate markets currently optimistically expect small rate rises in both the Eurozone and the US, but not in the UK and Japan. This optimism seems misplaced given the debt trends.
If the market reprices curves to expect lower interest rates for longer, that should prove to be a tailwind for hunt for yield trades which are being supported by the huge QE programs.
Introduction :
The announced $ 2trn aide package for the Covid19 fallout (on top of the already committed $ 1trn 2020 budget deficit) will add to an already large outstanding US Federal debt stock. What does that mean going forward for US Debt/GDP ratios and what are the implications for the interest rate curve?
The chart above uses data from the Fed Flow of Funds, that goes back to 1945:
GDP (Green). I assume a 5% contraction in 2020 (too high/too low?) and then a return to the 4% Nominal growth seen in 2019 for the next 10 years.
US debt is a combination of Federal and State debt. I assume a $3trn increase in 2020 and then a return to the 6.0% growth seen in 2019 for the next 10 years.
The Debt/GDP ratio is simply the ratio of the two. It hits 150% in 2030.
I don't think these are over pessimistic assumptions. Nominal US GDP has averaged 3.7% since 2009 (and 4.0% since 2015) following the massive stimulus post GFC that saw large budget deficits and very low interest rates. With regards to debt, the average debt growth in the 2008 to 2012 period was 15% p.a.(!). Ignoring this period, the debt has grown by an average of 4.7% p.a. since 2013, rising to 6.0% for the last 2 years. Assuming either Trump stays in power or a Democrat gets elected, its' pretty hard to see a reduction in debt growth from these growth rates - if anything it could be higher.
There are only two countries that I have seen to be able to substantially reduce their debt levels in recent history : Germany and Ireland. Both had large current account surpluses and a pretty unique set of circumstances (strong manufacturing exports, low corp tax rates, competitive advantages to neighbours, etc.).
For the reasons explained in https://www.thegreyfirehorse.com/post/the-premature-end-of-low-bond-yields interest rates become stuck at the lower bound when debt gets too large. A further increase in debt to GDP will just cement that reasoning.
In early 2014 I started looking at "Japanification of the Eurozone" interest rate trades, expecting that the forward interest curve would converge to the Japanese one, and that curve dynamics would change. Although interest rates were low in Europe, the market priced that interest rates would rise in the future, something that was unlikely due to economic, debt and fiscal policy stances. Today the Japanese and Eurozone forward interest rate curves have indeed converged and now entwine each other.
This raises the issue of interest rate expectations in other highly indebted countries, like the US and UK, who are going to see their leverage rise in forthcoming years. the chart below (data from Bloomberg) shows the forward interest rate swap curves for the US, UK, Eurozone and Japan (1 year forwards to be precise). Some features stand out:
The recent rally lower in interest rates has brought forward curves much much lower in the US over the last 2 months. The 1 year rate in 5 years time was ~2.0% at the beginning of the year and is now a mere 0.8%.
There is still optimism that rates will rise (in c. 2 years time ) in the US and Europe, less so in the UK and Japan (see how flat the latter two curves are compared to the Eur and US curves).
Interest rate expectations in the very long term are lower than in the medium term (where there are "humps") - this is a clear demonstration that Insurance and Pension companies are in a state of distress (more on that another time).
Despite Brexit looming on top of the Covid19 issue, the market does not expect a full "Japanification" of the UK curve.
This leads to some interesting medium term opportunities (especially when vol dissipates), some of which also are carry positive in a low interest world:
The 15 year part of the Eur curve looks too high.
Japanification of the US curve (sounds as mad as Japanification of the Eur curve 6 years ago!)
Rally of the UK curve to the EUR curve.
If these are correct, and government bond curves converge to swap curves as has happened in Japan (due to the QE programs), then the grab for yield will only increase, hugely supported by QE itself. It's not all doom and gloom, but there are different ways to play the same trade, but with far different risks attached!