Weekly Market Update

Debt crises do occur. For government borrowers, there have been many sovereign defaults, generally among smaller economies borrowing in foreign currencies they don’t control (most often the US dollar).

In the US itself, the events of 2008 were undoubtedly a debt crisis. However, this was driven by very poor lending standards for home mortgage borrowers unable to repay shaky housing investments.

US government debt since 2008 has been rising rapidly on a bi-partisan basis. The US Treasury, however, sits in an unusual place ahead of the world’s other borrowers in accessing credit from domestic (77%) and international lenders (23%) to be the world’s largest debtor.

Unlike other developed economies, the bulk of government support for healthcare spending is age-triggered rather than birth triggered. Driven by the world’s most expensive healthcare costs per unit (according to The Organization for Economic Cooperation and Development data), and limited direct revenue collections for Medicare spending, an aging population has a larger impact on US debt creation than other economies which generally cover or insure healthcare spending from birth.

How the US Congress determines to spend, tax, and borrow in the future is an open question. Current law would leave a trajectory of rising spending and deficits relative to GDP in the decade ahead.

However, US budget projections that embed long-term interest rate expectations quite close to current levels seem entirely plausible.

Another unique feature of US borrowing is the existence of a statutory “debt ceiling.” Enacted at the time of World War I, Congress must ratify its borrowing plans — including servicing existing debt — after making decisions to tax and spend.

On occasion, a few US policymakers have threatened intentional default rather than raise the debt ceiling which has increased almost annually since the early 20th century. The threat of intentional default is political rather than a result of market forces. As such, it should be considered a relatively remote risk to the world economy and financial markets.

But what determines the US’s cost and ability to borrow now? The periods of the largest immediate debt issuance — to support economic stabilization — generally occur during recessions.

Therefore, short-term and even long-term interest rates are negatively correlated with US budget deficits.

Periods of economic weakness tend to be times when savers are risk averse and gladly add to low-risk fixed income holdings rather than allocate more to risk assets, pushing down yields.

In 2020, when U.S. borrowing rose a record $4.3 trillion, US 10-year Treasury yields fell to a record low 0.5%. As the economy recovered, net borrowing fell to $2.4 trillion last year, while 10-year US Treasury yields rising to about 4% at year-end.

One of the Dollar’s great strengths is the Federal Reserve’s commitment to low inflation. Many have been shocked by the U.S. central bank raising interest rates so high that it has forced up government borrowing costs while marking down the value of the Fed’s own bond portfolio.

History, however, suggests that the Fed is actually limiting future borrowing costs for the US Treasury by maintaining the dollar’s credibility.