As markets shrug off soaring U.S. debt, we unpack the debt dilemma and argue that positioning portfolios for a debt crisis can lead to subpar returns.
December 7, 2023
By Atul Bhatia, CFA
Late last year, we expressed a relatively sanguine view on
U.S. debt levels. Since then, the U.S. fiscal position has undeniably deteriorated:
debt-to-GDP has moved higher, debt servicing costs increased, and the
Congressional Budget Office’s projected fiscal balances shifted deeper
into deficits. In short, the U.S. has more debt, more expensive debt, and
is adding to the burden at a faster pace. Rating agencies have taken note,
with fiscal policy and government dysfunction causing the U.S. to lose its
At least for now, however, markets are shrugging off the news. As of Dec.
6, equity and bond markets were higher on the year, and the dollar had
appreciated against trading partner currencies – a strange result if
investors were worried about rising U.S. government credit risk.
We expect this behaviour to continue and for asset prices to ignore U.S.
debt levels. Longer-term, we continue to believe that investment plans
built around any potential U.S. debt crisis are likely to underperform a
balanced portfolio by significant amounts.
The federal government has an astonishing $33 trillion in debt. Even after
eliminating borrowing between various government agencies and adjusting
for the growth of the economy, the only comparable debt in modern U.S.
history was after World War II.
But that particular measurement – debt owed directly by the U.S. government
to investors – is not the only measure of financial leverage in the overall
economy. Households, banks, local governments, and non-financial
corporations all rely on borrowed money to varying extents. And in these
other areas, the U.S. doesn’t look so bad.
The column chart shows debt including bonds, loans, and debt
securities as a percentage of 2022 gross domestic product (GDP) for
Canada (322%), China (272%), Germany (194%), Ireland (219%), Italy
(254%), Sweden (274%), the UK (252%), and the United States (273%).
Total debt for each country is made up of non-financial corporate
debt, household debt, and general government debt.
Source – International Monetary Fund
This borrowing by lower-level entities has two impacts on a nation’s
One is the direct impact. Borrowing by households, for instance, tends to
reduce future consumption as resources are diverted to debt servicing. At
a macro level, there is little difference if GDP growth is under pressure
from debt-laden governments or over-leveraged households – the economic risk
and pain are substantially the same.
The other concern is that in a crisis this non-government debt will
ultimately have to be backed by the entire nation and, as such, should be
viewed as contingent obligations of the central government. The
quintessential example, in our view, is the global financial crisis, when
bank and household mortgage debt was effectively backstopped by an
alphabet soup of government programmes.
While we don’t see a repeat of 2008 in the offing, we do think it’s
important to contextualise debt data between countries. Germany’s federal
debt is extremely low by international standards, but its banking system
liabilities relative to GDP nearly triples that of the U.S. China is a net
creditor at the national level, but the picture shifts when including
substantial municipal and local government debt – a factor in Moody’s recent
decision to shift to a negative outlook on the world’s second-largest
economy. Closer to the U.S., Canada’s federal debt is low, but households
have built up a substantial debt burden – nearly 50 percent larger than the
U.S. numbers adjusted for GDP.
Ignoring these liabilities and focusing only on central government debt
ignores the similarities in the day-to-day impact of leverage on the
broader economy, and also ignores the potential for a rapid and unforeseen
increase in national debt in a crisis.
Say what you will about the U.S. appropriations process, it’s an
open book . This transparency is another underappreciated strength of the U.S. in
terms of debt crisis risk.
Financial crises tend to arise when there is a rapid, unforeseen event.
Problems with a long lead time tend to get resolved with adjustments
instead of shocks. And this is what we see as likely: a gradual shift
toward fiscal balance as the cost of debt funding erodes the value of tax
cuts and higher spending.
Even though we think a gradual adjustment is likely, we don’t expect it to
be anytime soon.
To begin with, not many people really care about fixing the problem.
Surveys of even self-described fiscal hawks show that when it comes to
ranking policy choices, debt reduction falls below tax cuts and
identifiable spending priorities. In short, everyone wants debt reduction
if someone else makes the sacrifice. That’s a political non-starter.
The overarching problem with pushing for lower debt levels is the
near-total lack of evidence on what debt level creates problems for
countries that issue bonds in their own currency. The best evidence we
have is negative: Japan shows us that debt-to-GDP over 200 percent is not
incompatible with low interest rates and low perceived default risk.
Beyond that, we are in terra incognita.
This lack of empirical data cuts both ways. It makes it perfectly
plausible to argue that the U.S. is on the cusp of losing investor
confidence because of its large stock of outstanding debt.
For investors who remain convinced that a U.S. debt crisis is inevitable,
we think bond financing markets are one clear indicator that there is no
Most bonds are financed using repurchase agreements, more commonly known
as repos. A repo is essentially a short-term loan with bonds offered as
collateral. Most repo loans are repaid within a day, meaning that lenders
typically risk millions of dollars of cash to earn mere hundreds of
dollars in interest. Odds like that tend to focus the mind on collateral
quality, to say the least.
In repo markets, across all the different bond issuers, U.S. Treasuries
are the preferred asset type for most lenders. Borrowers with Treasury
collateral, broadly speaking, can borrow more and pay less than investors
who offer other bonds as security. We see repo lenders as having the best
claim to “canary in the coal mine” status for U.S. credit risk, and they
are chirping happily as far as we can see.
For at least 40 years, we have been hearing how U.S. fiscal imbalances are
unsustainable. And for all that time those imbalances have been sustained,
the U.S. economy has grown, and financial markets have generated positive
Given this outcome, we find it somewhat surprising that the press
continues to attach so much importance to U.S. debt levels. People
generally focus on strategies that have worked, and this input has been an
unmitigated failure for decades. We think that history is likely to
continue and that positioning for a U.S. debt crisis is likely to lead to
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