- The current U.S. debt burden, although elevated, is manageable due to low debt service costs, strong demand for U.S. Treasury securities and expectations for stronger economic growth
- The passage of another U.S. fiscal package has raised concerns about whether the growing U.S. debt and deficit will lead to even more inflationary pressure
- The recent rise in intermediate- and long-term interest rates in the U.S. is primarily driven by an improving economic backdrop and a rise in inflation expectations rather than higher debt levels
- A near-term pickup in inflation will likely be transitory and therefore will not have a longstanding, material impact on interest rates
- Longer term, policymakers and politicians will need to address rising debt and deficits through a combination of budget constraints and revenue increases
Sovereign debt and deficits across most developed economies are at historic levels due to massive fiscal spending amid the COVID-19 pandemic. In the U.S., government debt is approaching levels not seen since World War II, with a new $1.9 trillion COVID-19 relief package adding further to these levels.
While the speed and magnitude of the fiscal response over the past year has helped prevent a deeper global economic downturn, there is increasing concern that rising debt and a widening deficit may have negative consequences for the U.S. economy and markets down the road. To assess these concerns, let’s provide some historical context for the current debt and deficit levels and review the near- and long-term economic consequences.
At the end of 2019, prior to the pandemic, U. S. government debt held by the public totaled $16.8 trillion, equating to 79% of gross domestic product (GDP). By the end of 2020, after policymakers had passed multiple COVID-19 relief bills, U.S. debt had increased to $21 trillion, representing 100% of GDP. The Congressional Budget Office (CBO) projects this to increase to $22.5 trillion by the end of 2021, or 102.3% of GDP. Even before incorporating the $1.9 trillion stimulus package just passed by Congress, debt levels far exceed the average debt levels over the past 50 years. In comparison, back in 2007, before the onset of the last recession, U.S debt represented just 35% of GDP. The prior peak was in 1946, when debt-to-GDP was 104%, driven by spending incurred during World War II (see Exhibit 1).
Exhibit 1: Federal Debt Held by the Public as a Percentage of GDP
The pandemic-driven fiscal spending has concurrently increased the U.S. deficit – the difference between government outlays and revenues – from $980 billion at the end of 2019 to $3.1 trillion at the end of 2020. This increased the deficit-to-GDP ratio from 4.6% in 2019 to 14.9% in 2020, the highest level on record. The CBO projects the 2021 $1.9 trillion relief package will add another $1.2 trillion to the deficit in 2021 and an additional $429 billion in 2022. The deficit, not accounting for the most recent $1.9 trillion relief package, is projected to decline to $1.2 trillion a year from 2022-2031, equating to 4% of GDP, closer to historical averages (see Exhibit 2). The projected decline in the deficit is primarily due to increased GDP growth as well as the scheduled sunset of tax cuts at the end of 2025, both resulting in increased tax revenues.
Exhibit 2: Deficit to GDP
Near-term Consequences Manageable
While these historically high levels of national debt and deficit are concerning, we believe they are manageable over the near-to-intermediate term for several reasons. These reasons include the low cost to service this debt, continued broad demand for U.S. Treasuries globally given the reserve status of the U.S. dollar, and an expected pickup in U.S. economic growth (GDP) to above-average trend growth as we emerge from the pandemic.
Despite the recent increase in U.S. debt, the cost to pay for (or service) this debt is quite manageable in historical terms and has actually fallen at the same time that the debt has risen. In general, interest rates are at historically low levels, in part due to the Federal Reserve’s commitment to keep short-term interest rates near zero, strong global demand for Treasuries and low inflation as a result of the pandemic. As illustrated in Exhibit 3, the average interest rate on U.S. public debt has been steadily declining over the past several decades, falling from almost 9% in 1988 to 2.5% in 2018, and down to 1.5% in 2020.
Exhibit 3: Interest Rates on Public Debt Historically Low
In fact, despite debt-to-GDP increasing from 35% back in 2007 to 100% in 2020, the cost to service this debt (net interest cost) actually decreased from 1.7% of GDP to 1.6% of GDP. This is explained by the interest rate levels on the outstanding debt falling precipitously over this period. In 2007, the three-month Treasury bill (T-Bill) and 10-year Treasury note were both yielding approximately 5%. In 2020, the three-month T-bill yield averaged 0.70% while the 10-year Treasury note averaged 1.10%. Given the profile of U.S. debt is short-term in nature, with an average maturity of 5.5 years, the net interest cost is very manageable. Even though net interest cost will increase as interest rates rise, the CBO projects an increase to 2.2% by 2050, only marginally higher the 50-year average net interest cost of 2%.
Additionally, when considering debt service costs as a share of overall federal spending, these levels also appear manageable. While these costs have generally been rising over the last several years, they remain well below levels seen in prior decades. In fiscal 2020, debt service costs amounted to 7.9% of total expenditures, while fiscal 2021 debt service costs are estimated to be 7.8% of total expenditures. In contrast, during much of the 1980s and 1990s these costs exceeded 12% of expenditures. Although service costs are projected to rise to 9.2% by 2025, they remain well below the peak levels at 15.4% of total federal spending seen in 1996 (see Exhibit 4).
Exhibit 4: Interest Payments on U.S. Debt Still Manageable
Another reason we feel these debt levels will be manageable has to do with the broad and diverse demand dynamics for U.S. Treasury securities. Treasury debt is held by both domestic and foreign entities. Domestic holders include individual investors, personal trusts, and corporations as well as mutual funds, financial institutions, pension and retirement funds, and state and local governments. Domestic holders account for approximately 63% of U.S. Treasury debt holders, while the remainder is held by foreign entities. As of the end of 2020, the 10 countries with the largest holdings were Japan, China, the United Kingdom, Ireland, Luxembourg, Brazil, Switzerland, Belgium, Taiwan and Hong Kong. The largest foreign holders of U.S debt are China and Japan, with each country holding approximately 6% of outstanding public debt as of the end of 2020 (see Exhibit 5). So while there are occasionally suggestions that the U.S.’s contentious relationship with China makes us vulnerable due to our reliance on China maintaining and purchasing our debt, China’s actual level of overall ownership of Treasuries is relatively small. Furthermore, with the U.S. dollar considered the global reserve currency, it’s reasonable to expect foreign demand for U.S. Treasury debt will remain strong helping to keep interest rates relatively low.
Exhibit 5: Holders of Treasury Debt
Lastly, we are also encouraged by the anticipated pickup in domestic economic growth in the quarters and years ahead as we fully recover from this pandemic. We expect real GDP (gross GDP less inflation) will reach its previous business-cycle peak (attained in the fourth quarter of 2019) by mid-to-late 2021. Current CBO projections, which incorporate current federal taxes and spending as of January 12, 2021, project an average annual growth of real GDP of 2.6% over the next five-year period, exceeding the 1.9 % growth rate of real potential GDP (see Exhibit 6). Strong, above trend GDP growth will lead to low unemployment and increased tax revenues for the federal government which will help to offset costs associated with debt service and lead to a reduction in the national debt and deficits.
Exhibit 6: The Relationship Between Real GDP and Potential GDP
While the near-term challenges associated with elevated government debt are manageable given today’s historically low rate environment, there is concern that all of this stimulus will lead to higher interest rates and a rise in inflation. As we entered 2021, we had forecast for a modest rise in interest rates and have seen the benchmark 10-year Treasury note increase over 60 basis points since the start of the year. This adjustment in rates is being driven by the bond market’s recognition that the economy is doing better, rather than concern about the growing deficit. In fact, in the near to intermediate term, we don’t believe the growing debt and deficit will play a major role in pushing rates higher.
It is certainly possible that we will see a near-term increase in inflation and this latest round of stimulus may add additional pressure. However, the Federal Reserve’s measure of inflation, the personal consumption expenditures (PCE) price index, is still shy of its 2% target, up 1.5% in January from a year ago. But, in the central bank’s most recent minutes, it stated that inflation will likely increase above its target of 2% for a brief period this spring as the unusually low inflation readings from last spring roll off the 12-month calculations. If we do get a near-term burst of inflation, we believe it will be demand driven given the pent-up demand for services and could be a contributing factor to a modest rise in interest rates. We agree with the Fed that a rise in inflation will likely be transient and that it will not have a longstanding material impact on interest rates. We remind investors that inflation had been tame in the years heading into the pandemic in part due to several deflationary forces. These forces, which include the globalization of supply chains, an increase in productivity as a result of technology innovation and aging demographics, are structural in nature and therefore should keep outsized inflation at bay.
Does it Affect Investors?
We have anticipated rising rates from the start of the year given our expectations that economic growth will recover to pre-crisis levels by mid-to-late 2021. For this reason, we have been watchful of interest rates and have taken steps to mitigate the risk of higher interest rates in managing client portfolios. We have underweighted fixed income within a broadly diversified portfolio rather than eliminating exposure to the asset class all together. Within bond portfolios, we continue to underweight Treasuries where applicable and utilize Treasury Inflation-Protected Securities (TIPS) as a substitute for nominal Treasuries in taxable accounts. As we often remind clients, a high-quality bond portfolio should also incorporate a mix of specialized strategies including floating rate and fixed-rate high yield debt as well as opportunistic fixed income strategies, which tend to be less sensitive to interest rates. Additionally, we believe having a broadly diversified portfolio of equity and fixed income securities, both domestic and international, should serve our clients well over the next 12 to 18 months.
The Bottom Line
While pandemic relief has caused an already elevated level of U.S. debt and deficit to reach concerning levels, this spending has been necessary to help get the U.S. economy to the other side of the global pandemic while avoiding a more prolonged recession. The latest round of fiscal stimulus may add to inflationary pressures, but we continue to believe any pick-up in inflation will be transitory and lead to only modestly higher rates. Nevertheless, we continue to monitor interest rates and inflation as the economy returns to pre-pandemic levels and to actively manage our client portfolios to mitigate these potential risks.
Our view continues to be that the increasing level of U.S. debt and deficit, while concerning, is manageable in the short to intermediate term given our expectations that rates will only rise modestly as the economy improves. Additionally, the reserve status of the U.S. dollar and extremely high credit quality of our debt will likely support continued demand for U.S. Treasury securities going forward. However, this burden of debt is unsustainable longer term. It will likely require policymakers and politicians to address this challenge through a combination of reduced spending and increased revenue in order to bring down U.S. debt ratios and put them on a more sustainable path.