Bond markets are not taking into account the trajectory of US debt, for now. Pimco Report
Debt levels will likely continue to rise in the absence of policy changes and the yield curve is set to… Analysis by Libby Cantrill, Head of Public Policy, and Rich Clarida, Global Economic Advisor at Pimco
With bond yields falling in recent months, it appears that rising US government debt is not top of mind for investors. However, many investors have questioned whether America's debt path is sustainable, whether policymakers plan to do something about it, and whether bond vigilantes will end up driving up borrowing costs. While some of the factors driving the deficit increase will abate in 2023, in the long run they will likely be replaced by increasingly larger and more persistent drivers, particularly the growing share of spending on Medicare and Social Security.
Absent changes to mandatory spending or taxes, which we do not think are likely in the coming years, we think the market will eventually demand – and get – a premium for holding longer-dated Treasuries and that this will lead to a yield curve Americans steeper over time. For clarity, while the long-term debt trajectory is problematic, we do not believe there will be a fiscal crisis in the United States anytime soon and we continue to believe Treasuries are an important component of an asset allocation strategy.
THE “PERFECT STORM” OF THE DEFICIT OCCURRED IN 2023
Last year, the US budget deficit reached nearly $2 trillion[1], or 7.5% of GDP – more than double its 50-year average of 3.7% – with a revenue decline of 9% and an increase in spending of 11%, according to the Congressional Budget Office (CBO)[2]. Granted, some of the deficit increase was driven by temporary, one-off factors, such as increased use of expiring COvid-era tax credits, Federal Deposit Insurance Corporation support for Silicon Valley Bank , and a one-time adjustment cost of living payments to social security benefits.
However, one of the most important factors – amounting to more than $700 billion, almost as much as the Pentagon 's budget – was the cost of servicing the US debt. As a percentage of GDP, interest spending will reach 2.9% of outlays in 2023, versus a 50-year average of 1.9%.
A WORRYING TRAJECTORY
Longer term, CBO expects outstanding federal debt to grow to 172% of GDP by 2054, up from 98% in 2023, while interest spending could reach 6.5% of GDP. Of course, these figures are based on assumptions that may not materialize, but the direction of travel is clear and disconcerting in the absence of policy changes.
Even more concerning, CBO projects that, as the U.S. population ages, Medicare and Social Security and other health obligations will grow to more than two-thirds of all non-interest spending by 2053, compared midway today.[3] While the Inflation Reduction Act of 2022 made incremental changes to the cost of healthcare drugs, the cost curve for other areas of healthcare will continue to rise in the absence of reform.
WHAT DO POLITICIANS DO ABOUT IT?
In some ways, the politics of austerity has returned to Capitol Hill, as evidenced by recent fiscal fights over government financing and the debt ceiling. Ironically, though, these fights have been over a relatively small piece of the government pie — discretionary spending — that Congress authorizes each year to fund everything from the Pentagon to national parks to cancer research. While essential, this spending amounts to just over a quarter of the government's $6.4 trillion budget, or $1.7 trillion, and is expected to decline as a percentage of GDP over the long term.
At the same time, presidential candidates of both parties have vowed not to touch Medicare or Social Security, even for future beneficiaries. Both have said they will likely extend, at least in part, the expiring tax provisions in the Tax Cuts and Jobs Act of 2017 to the end of 2025. Depending on the details, that could add another $3 or $4 trillion to states' debt United in 10 years.
Given what both presidential candidates have indicated, significant changes on the revenue or spending front are unlikely to occur until at least 2029.
IMPLICATIONS FOR MARKETS
At our last secular forum in May 2023, we concluded that “as government debt rises… we expect the yield curve to steepen, as investors demand more compensation on longer-term bonds” in the coming years. At the same time, as we concluded at our secular forum, the US dollar will likely maintain its status as the dominant global currency, despite the widening US fiscal gap and growing indebtedness. We therefore believe there will be a limit to the rise in yields as long as the dollar and US Treasuries remain the “cleanest dirty shirt” in the global sovereign bond market closet.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/i-mercati-obbligazionari-non-tengono-conto-della-traiettoria-del-debito-usa-per-ora-report-pimco/ on Sat, 09 Mar 2024 06:45:10 +0000.