Fed rate cut buys U.S. time, but no quick fix to debt

By Atul Bhatia, CFA

Lower financing costs can help slow debt accumulation, but we believe they are unlikely to make the country’s fiscal policy sustainable in the long term. Instead, we think it’s increasingly clear that the U.S. will resort to several of the tried-and-true tactics of overindebted sovereigns, such as currency devaluation and bond market interventions, to mask some of the costs of profligacy. While we don’t see even a miniscule chance of a U.S. default, we do see implications for multiple asset classes as the U.S. confronts its unwillingness to tax at levels commensurate with its spending.

A rolling loan gathers no loss

The easiest way to deal with debt maturities is to repay them with borrowed money, a process often referred to as “rolling over.” There’s nothing inherently risky with the maneuver. Many companies – including highly rated, cash-rich enterprises – routinely pay off maturing bonds with new debt.

For countries, it’s largely the same. No one, we believe, would argue that zero debt is the only sound way to run an economy. The question is how much debt the economy can reasonably carry and roll forward on an ongoing basis. Unfortunately, there is no sound empirical or theoretical answer to that question, but we think 60 percent of GDP – or roughly half the current U.S. debt burden – is a ballpark, if likely conservative, number to use.

If not rolled, then what?

Beyond that, there are some innocuous ways of reducing the excessive levels of U.S. borrowing:

• Grow into it: If the growth rate of the U.S. economy exceeds the average interest rate paid on the debt – and the government keeps the budget roughly balanced before interest costs – then the debt-to-GDP ratio can drop over time. Strictly speaking, growth doesn’t reduce debt as much as mitigate the harms. This go-slow approach, however, entails less political pain than quicker fixes.
• Fiscal surpluses: The fastest way to reduce debt is to manage the federal budget in a prudent manner: raise taxes – whether income, corporate, or tariffs – and/or cut spending until income exceeds expenditure. The economic problem with this approach is that it’s contractionary – it tends to slow economic growth by using today’s resources to pay for the party we already had. The political problem is that taxes are unpopular, and government checks are welcome. Fiscal discipline may poll well, but as an electoral strategy, it’s a proven loser.

It’s good to be sovereign

For a company or a household, these are the only options: chipping away slowly or ripping the bandage off. But individuals and businesses can’t print their own money nor set their own borrowing terms. Governments – particularly the U.S. government – can do both.

As for setting the terms of borrowing, that’s essentially what the Fed did yesterday. As part of implementing its new 4.00 percent to 4.25 percent overnight interest target, the Fed will offer cheaper funding to certain private entities to purchase government securities, thereby setting a lower effective ceiling on what newly issued, short-term debt can cost the U.S.

Longer-maturity government debt – such as that maturing in 10 years or more – is less directly influenced by the Fed. With the higher volatility of these bond prices and the greater uncertainty around future economic developments, it’s a riskier proposition for private investors to rely on the Fed’s short-term funding to buy longer bonds.

This is where the Treasury can act. In addition to increasing the pace of buybacks of longer-maturity debt, the Treasury has increasingly relied on loans maturing in a year or less to fund its operations. Reasonable people can certainly differ on when changing issuance patterns stops being proactive liability management and tips into manipulating the yield curve, and we don’t think those labels are helpful. What is fair to say, in our view, is that reliance on bills introduces higher risk to U.S. government finances as it provides less visibility into funding costs. It also, we believe, increases pressure on the Fed to keep short-term rates low as a way of avoiding the negative economic consequences that would follow from a sharp rise in U.S. borrowing costs.

The Treasury – whether alone or in conjunction with the Fed – has other levers it can pull, such as capital controls or requiring additional government bond purchases from regulated institutions. To date, there is little indication that these are likely outcomes; nonetheless, they remain in its toolkit.

Pick a price, any price

The final way that sovereigns deal with debt is through inflation. Whether this is truly a planned outcome or just a result of choosing the least painful path of high spending, low taxes, and low overnight interest rates is an open question, but mainly an academic one. Higher prices are higher prices, whether directly intended or merely tolerated.

Economists traditionally talk about inflation through the lens of consumer prices, but there’s a strong case to be made, we believe, that government profligacy can also show up in asset prices, depending on the distribution of gains to households. Lower-income households tend to spend a greater percentage of increased earnings, while higher-income households tend to invest more of any newfound cash. So, in a situation where government deficits are primarily improving the finances of upper-income households, we would expect increased demand for investment assets, such as gold, stocks, and homes. We think it’s no coincidence that these assets are at or near their all-time highs.

The other way of thinking about asset price inflation resulting from U.S. government deficits and debt is through currency. Artificially low rates, policy volatility, and concerns on debt levels have played a role, in our view, in the dollar’s 10 percent year-to-date depreciation against its major counterparts. For investments measured in dollars, the shorter yardstick of value makes it easier to have high nominal returns.

Easy path, tough destination?

It’s hardly a bold call to predict that politicians will choose the path of least resistance and greatest popularity. Unfortunately for holders of U.S. debt, that means a likely future of artificially low rates, relative underperformance versus other asset classes, and the possibility that nominal gains could be eroded through the specter of higher prices.

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