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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is global chief economist at Citigroup
US fiscal performance has reached new depths of dysfunction. In recent months, the country has endured a stressful debt-ceiling episode, Fitch has downgraded the US sovereign credit rating and the risk of a government shutdown remains on the table.
Equally concerning, the federal government is swimming in a sea of red ink, with budget deficits near 6 per cent of gross domestic product likely in the years ahead. As a result, the government’s debt is poised to rise to 115 per cent of gross domestic product over the next decade, surpassing its peak after the second world war.
These large deficits and rising indebtedness pose risks to the economy. On reasonable estimates, the Treasury will need to issue $20tn of debt in the coming decade. The magnitude of this issuance is not lost on market participants. In recent months, the most frequent question during my meetings with investors around the world is “who’s going to buy this massive issuance of Treasuries?”
This question is often followed by two others: how much debt is simply “too much”? And what might a full-blown crisis in the US Treasury market look like? The UK gilt crisis last year stands as an important template in this regard. Could something similar — and perhaps even more sustained — occur in the US?
In sync, Treasury yields have risen sharply from a year ago. Propelled by the Federal Reserve’s “higher for longer” policy stance and heightened concerns about fiscal sustainability, 10-year yields reached a peak of about 5 per cent in October. More recently, rates have retreated to the mid-4 per cent range, as Fed rhetoric has become more balanced and inflation readings have moderated.
Our research on the US public debt situation from historical and international perspectives suggests several conclusions. First, the question of who will buy the newly issued debt is inherently speculative. But, in our view, the desire of the ageing population to hold safe long-duration assets as a store of value for retirement is likely to be the main source of demand. Such purchases, either directly from retail investors or through their intermediaries, are likely to be more price sensitive than before the pandemic.
Second, there is no way to predict danger thresholds or the amount of debt that is simply “too much”. It is possible that US debt could rise to 150 per cent of GDP or even higher with limited adverse effects. But it is unwise for policymakers to experiment or test where the thresholds might be. The prudent path for fiscal policy is, at a minimum, to not push debt ratios further upward from today’s elevated levels.
Even so, there is little likelihood of meaningful remedial action. A successful strategy would probably require some combination of higher taxes and reduced expenditures.
Notably, getting traction on expenditures will require tough reforms to entitlements and defence, which comprise roughly three-quarters of US federal spending. Republicans are broadly unwilling to entertain discussions of tax rises, while Democrats are similarly unwilling to contemplate entitlement reforms, so the fiscal situation has remained in stalemate. The headwinds to growth that would likely accompany fiscal retrenchment are a further source of reluctance.
Third, last year’s UK gilt crisis offers a cautionary tale. The hallmark of an adverse scenario in the Treasury market would be a sharp, unexpected deterioration in investor demand for securities. The result would be surging Treasury yields and rising risk premiums in credit and equity markets. Given the dollar’s status as a global reserve currency, these stresses would be transmitted to financial markets abroad.
Nevertheless, the most likely scenario is that investor discomfort regarding the debt eventually recedes, and the situation reverts to the more relaxed pre-Covid configuration. If so, any premiums the market requires to absorb the forthcoming issuance would be modest.
The core strengths of the US economy — including the dollar’s reserve currency status, the Fed’s credibility and the strength of the overall national balance sheet — should give investors the confidence to purchase the additional debt. At the end of the day, there are few alternatives to Treasuries, and the high US debt levels are an unfortunate, but unavoidable, fact of life.
Even so, there is little scope for complacency. Investor patience has limits. The markets are likely to issue the US a reprieve — but not a full, unconditional pardon.