U.S. public debt: An inflexion point is coming. No one knows when
Over the period since the global financial crisis beginning in 2008, the U.S. Federal Reserve (Fed) has seen the yield on three-month treasury bills trade at a premium relative to the U.S. consumer price index (CPI) for less than 5 per cent of the 16.5 year period in question.
To what degree has this “near zero interest rate policy” promoted poor fiscal behaviour? U.S. public debt, for example, has jumped from U.S.$5.5 trillion to the current U.S.$35 trillion, a compound annual average growth rate exceeding 12 per cent, and it seems increasingly likely the medium-term budget deficit and indebtedness forecasts from the Congressional Budget Office will prove optimistic.
The U.S. public debt to gross domestic product (GDP) ratio has more than tripled from 37 per cent in 2008 (U.S.$5.5 trillion/ U.S.$14.8 trillion) to an estimated 122 per cent (U.S.$35 trillion/ U.S.$28.8 trillion) in 2024. Given that neither political party seems keen on a balanced budget, I believe an inflexion point from increasing debt, higher interest charges, and greater defence expenditure may not be far away.
What this means is the market will eventually demand a higher premium to lend the U.S. government money to fund their budget deficit, typically closer to 3.5 per cent over long-term inflationary expectations. What happens if inflationary expectations settle at over 3 per cent? The U.S. ten-year bonds have further upside to yield 6.5 per cent, and this compares with the record low of 0.5 per cent recorded in mid-2020 and the recent high of 5.0 per cent recorded in October 2023.
If we analyse U.S. CPI growth over the 46-year period from 1962 to 2007, inclusively, and delete the highest consecutive six-year period, from 1977 to 1982, inclusively, we end up with a 40-year average inflation rate of 3.5 per cent. Based on this data, it seems to me a target on the U.S. ten-year bond yield of 6.5 to 7.0 per cent is a possibility. What I find interesting is virtually no one thinks this can happen.
As investors, we need to consider this possibility and ask ourselves what are the ramifications valuations if U.S. ten-year bond yields exceeded the October 2023 high of 5.0 per cent? Furthermore, what if the market then thought a ten-year bond yield of 6.5 to 7.0 per cent was a possibility?
Chief Executive Officer of Montgomery Investment Management, David Buckland has over 30 years of industry experience. David is a deeply knowledgeable and highly experienced financial services executive. Prior to joining Montgomery in 2012, David was CEO and Executive Director of Hunter Hall for 11 years, as well as a Director at JP Morgan in Sydney and London for eight years.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
