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AUGUST 2020 CLIENT QUESTION: FEDERAL DEBT

Client Question of the Month |

by Andrew Murphy, CFA Senior Director, Portfolio Management

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The federal debt has become a hot button issue in recent years and especially in the last several months as the government has significantly increased its borrowing to combat the effects of the coronavirus. The amount of debt held by the public has risen this year by almost 20% to a total of $20.7 trillion. While the debt level increase has shocked some people, it was likely necessary to avoid a more severe economic downturn. In our August Client Question of the Month, we thought it would be helpful to answer the most common questions associated with the federal debt.

What is the Federal Debt?

The federal debt is simply the amount of money that the United States federal government has previously borrowed and subsequently owes. When the government borrows money, the Treasury Department sells securities to investors in the form of bills, notes, and bonds. Treasury securities (“Treasuries”) are backed by the full faith and credit of the United States, which means their principal and interest payments are effectively assured by the government. Treasuries are offered in a wide range of maturities, are exempt from state and local taxes, and are usually very liquid.

The two basic measures of federal debt are debt held by the public and gross debt:

Debt held by the public: the most common measure of federal debt and includes debt held by individuals, institutional investors, the Federal Reserve, state and local governments, and international investors. As of August 31, 2020, the total amount of US debt held by the public was $20.7 trillion.

Gross debt: includes debt held by the public plus debt held by federal trust funds and other government accounts. Social security comprises the largest percentage of debt held by federal trust funds and other government programs. As of August 31, 2020, the total amount of US gross debt was $26.6 trillion.

Source: Federal Reserve Bank of St. Louis

What drives the Federal Debt level?

The growth of federal debt is driven primarily by the government budget deficit. When spending exceeds revenue, the government is running a deficit. When the government incurs a budget deficit, the Treasury sells securities and uses the proceeds to fill the gap between revenue and expenses. Essentially the federal debt is the total accumulation of historical deficits. Typically, government deficits and debt have increased during periods of economic weakness and declined during expansions.

Due to the amount of stimulus announced, the government budget deficit is estimated to reach $3.7 trillion and $2.1 trillion in 2020 and 2021 respectively, according to the Congressional Budget Office (CBO).

Source: CBO

What are the risks of too much debt?

The CBO describes that too much debt has two main consequences:

  1. High debt levels decrease economic output over time. As debt levels increase, the government is forced to spend more of its budget on interest costs.
  2. Higher interest costs would increase payments to international debt holders, and therefore reduce the income of US households.

Does the debt need to be paid off?

The debt does not need to paid off in full, however the government does need to ensure that interest payments are sustainable. Rather than eliminating the debt, the government manages the debt by including interest costs as part of their overall spending.

The government’s interest cost is defined as the payments on federal debt offset by the income received from various sources. The two primary factors that impact interest cost are the amount of debt outstanding and the interest rate on Treasury securities. The interest cost provides important context on how the government can service their debt payments.

In the last period, interest cost was about 8.4% of government spending – this is still below the average level of 9.1% since 1945. This percentage will increase due to the added debt level. However, given that interest rates are at historic lows, the interest cost-to-government spending ratio should remain below the peak levels of the mid-1990s.

Source: Federal Reserve Bank of St. Louis

Given low interest rates, was this a good time to increase the debt?

Yes. We would like to point out that given the historically low levels of interest rates, now is an ideal time to increase the debt level. To use a real-world example, a 30-year fixed rate mortgage with a principal of $615,000 and interest rate of 6.00% has the same monthly payment as a one with a principal of $1,000,000 and a 2.00% interest rate. Based on the current levels of interest rates, the debt is sustainable for now. However, we all know that interest rates can change and will likely not stay at their present levels forever. Given that, the government should at least capitalize on this period by lengthening the maturity of its outstanding debt (note – Treasury started issuing 20-year bonds and even considered 50- and 100-year bonds).

Can you put the debt level in context?

To compare amounts of debt in different years we thought it would be helpful to view both debt held by the public and interest cost in relation to the size of the economy (nominal GDP). The following chart shows the debt-to-GDP in orange and the interest cost-to-GDP in blue.

The debt-to-GDP ratio reached 106% in 1946 as the government borrowed heavily to finance defense spending during World War II. The ratio fell over the next several decades as the economy grew faster than the amount of outstanding debt. Since the Global Financial Crisis of 2008, debt levels have been rising significantly. The debt-to-GDP ratio will once again increase to over 100% this year as debt levels spiked and nominal GDP fell due to the coronavirus.

In the current period, the total interest cost is rising due to the increase in total debt, but lower interest rates are keeping the ratio below peak levels from the mid-1990s.

Source: Federal Reserve Bank of St. Louis

Why hasn’t the market demanded higher interest rates due to the increased debt level?

Counterintuitively, interest rates in the United States have fallen despite the increase in debt levels over the past several years. Long-term interest rates move based on supply and demand. Typically, you would expect that as the supply of Treasury bonds increase the demand will fall – this would push bond prices down and interest rates higher. The government would prefer to avoid higher interest rates since it would increase their overall interest costs. Notably, interest rates have not moved higher despite the increase in debt for two main reasons:

  1. US interest rates are still attractive for global investors. The Japanese and German 10-Year yields are now at -0.40% and +0.05% respectively. Currently, there is an estimated $14.2 trillion in global debt with negative yields. While the US 10-Year Treasury yield of 0.70% is near its all-time low, the current yield is still higher than many global rates.
  2. The Fed has become the major buyer of Treasuries and they are not price sensitive. Market strategist Ed Yardeni coined the phrase “Bond Vigilantes” in 1983 to describe investors who sold Treasuries when they thought government spending was getting out of hand. As a result, the federal government was forced to reign in their spending to avoid higher rates and interest costs. In today’s environment, the Fed has replaced the “Bond Vigilantes” as the major buyer of Treasuries. The Fed purchases Treasury bonds specifically to decrease interest rates and subsequently boost the economy, therefore they are not price sensitive. Through their quantitative easing programs, the Fed has purchased over $4 trillion in Treasuries (and climbing). Interest rates are unlikely to move materially higher for as long as the Fed remains a major buyer.

Where do we go from here?

The following four factors will have the biggest impact on the future of US government debt: government revenue (mainly tax policy), government spending, economic growth, and interest rates.

In a vacuum, each of the following events would increase/decrease the debt level:

We acknowledge that the government cannot count on interest rates remaining near zero forever, and thus they will need to at least cut the deficit to stop increasing the total debt. In the short term, there will be a fiery debate between Republicans and Democrats on the best way to cut the deficit. If Republicans control the government, they will likely argue that stronger economic growth will eventually cut the deficit and debt. If Democrats control the government, they will likely argue for higher revenue through increased taxes on corporations and/or wealthy individuals.

Conclusion

The national debt is a very complicated issue with no clear answer on at what point it becomes unsustainable or the best method to pay it down. Treasury Secretary Steven Mnuchin recently acknowledged that, “there is some limit to what we can borrow, but we are not at it yet.” Although overall debt levels have gone up during the coronavirus period, servicing the debt is still manageable given low interest rates. Since interest rates will not remain near zero forever, the government should implement methods to at least balance the budget once the coronavirus period is over. Once interest rates do start to rise, the government will be forced to make difficult decisions on how to pay down the debt.

At Winthrop Wealth, we apply a total net worth approach to both comprehensive financial planning and investment management. Financial planning drives the investment strategy and provides a roadmap to each client’s unique goals and objectives. The comprehensive financial plan defines cash flow needs, is stress tested for various market environments, optimizes account structures, considers tax minimization strategies, and continuously evaluates financial risks as circumstances and/or goals change. The investment management process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection.

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DISCLOSURES:

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

No investment strategy assures success or protects against loss. Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Rebalancing a portfolio may cause you to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss. All investing involves risk which you should be prepared to bear.