Andrew Pyle
February 24, 2023
Debt service, not ceiling, is where the focus needs to be
I thought we would take a pause from examining the impact on businesses and households from rising interest rates, though important in terms of economic and market direction, and look at what is happening on fiscal side of things. As most of you are aware, the US is in the middle of yet another debt-ceiling debate that is filled with all the anxiety, drama and tension that we have come to expect over the decades.
Technically, the US federal government has already pushed past its previously stated debt ceiling as of the end of January and the Treasury has about four month's worth of what are referred to as extraordinary measures, before time runs out. The debate is between the Republican stance that the debt ceiling may only be raised, provided there are spending cuts, and the Democrats who want the ceiling raised with no strings attached. Some of our clients and friends have been asking Ally and I whether this current debate represents a major risk to financial markets, with references to what happened in 2011.
That year seems like forever ago, but essentially it was a post mid-term Obama White House facing off against a freshly energized Republican majority in the House. The parties became so dug in that a final agreement was only reached at the very end of the process and only after the US had its triple-A credit rating cut for the first time ever. True, the government ended up not defaulting on its debt, but markets were negatively impacted. Over roughly a three-week period into August, the Dow Jones lost close to 16% and remained volatility into the fourth quarter. Hence, it is reasonable for investors to be concerned about the effects from the current debate going on in Washington.
That said, there are some key differences between what is happening today and the experience in 2011. For one, the Republican majority in the House is not as sizable as back then. There are a few dozen members who appear to be ready to take the economic train over the cliff, but there are more that are willing to compromise for the sake of getting a deal. On the Democrat side, there is also a contingent that will not agree to anything other than a zero-conditions debt ceiling upgrade; however, there are many that also see room for some bending. The main reason is that neither party, given such thin majorities in Congress, seems willing to create an economic chasm over an issue that has majority support among Americans.
So, let’s assume that a deal gets hammered out before the deadline and that we don’t fall off the cliff. We can all just turn off the business channel and go back to our regularly scheduled programming, right? Perhaps, but there is something else going on that could potentially make the debt ceiling debate small by comparison. I’m referring to the cost of servicing the level of debt the US already has and the increasing cost of new debt in this environment of rising interest rates.
Bond yields definitely are a lot higher than they have been in recent years, though still well below levels we saw before the financial crisis. The problem is that debt has risen well beyond those years, such that even a lower prevailing interest rate than say back 20 years ago, can still boost the cost of servicing debt. Back in the late 1990s, the 12-month cumulative net interest payments on Treasury debt were just over $200 billion. Last year, we hit $500 billion and that number is expected to rise.
The reason is that existing bonds with lower coupons are going to mature and be replaced with higher-yielding ones. Now, it isn’t as simple as that. Much depends on how the Treasury manages its debt issuance and what bonds are actually maturing. For example, a bond that was issued 10 years ago would have had a coupon in the neighbourhood of about 2%. A new 10-year bond issued today will carry a coupon closer to 3.8% (the current benchmark was issued last week and has a coupon of 3.87%). Then again, a bond issued 30 years ago would have given you a handsome coupon of just over 7%, compared to the current benchmark issued this month with a coupon of just over 3.5%.
The other complication to this story is what is happening at the Federal Reserve. Since the financial crisis, when the Fed engaged in quantitative easing (bond buying) the balance sheet at the Fed exploded to over $4 trillion by 2014. When the pandemic hit, assets ballooned to above $7 trillion and by the spring of last year, we came close to $9 trillion. Since then, the Fed has been engaged in quantitative tightening or balance sheet normalization. Essentially, the Fed can sell bonds that it holds into the secondary market, or it can simply not buy the bonds that the government issues to pay for the ones that are maturing on the Fed’s balance sheet.
When the Fed announced its tightening program last spring, it targeted a $1 trillion initial run-off. At the current pace, this would take total assets down to close to $8 trillion by the beginning of the summer. In a situation where inflation was about to return to the Fed’s target of 2%, you might imagine that the tightening would stop (rate hikes and quantitative tightening). Some analysts actually stated this would happen no longer than a few months ago. The problem is that inflation is extremely unlikely to reach 2% by the summer, which means that the Fed will probably extend the tightening program. That might be another $1 trillion reduction target or even more.
Some believe that we are entering what is called a debt spiral. This means that the cost of servicing the US debt continues to go up at an accelerating rate, making debt service a higher percentage of overall government spending. At some point, the government could find itself having to borrow just in order to make payments on its debt. We have seen this before across various countries (including our own) and it doesn’t always end in disaster. What it does do is push fiscal discipline further up the priority list and perhaps this look ahead to what might happen on the interest payments side could get parties together well before a last-minute debt ceiling debacle.
For now, we still believe the risk-reward characteristics of bonds still outweigh equities. That doesn’t mean we get out of stocks and bet everything on bonds, but for now that’s where the lower risk opportunity exists, in our opinion. If, however, an agreement on the ceiling doesn’t materialize or there is no serious recognition among politicians of the risk of a continued rise in debt servicing costs, then both markets would be at risk. This could be a long few months.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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