The importance of any piece of economic information depends on your time horizon. For traders, the issue is how it will move markets today. For politicians, its relevance lies in how it could shape public opinion between now and the next election. However, for long-term investors, what really matters is how it will impact the economic and financial environment for decades to come. From this last viewpoint, there is no more important topic than the continued deterioration in the federal finances.
Information released in the last few days provides an updated perspective on this issue. However, before delving into this, let’s take a quick look at upcoming economic data.
This week will be dominated by inflation news, with producer prices due out on Tuesday, CPI data released on Wednesday and import prices published on Thursday. The most important of these are the CPI numbers and we expect a 0.3% monthly gain in both headline and core CPI, with year-over-year increases edging down to 3.4% and 3.6% respectively. Our estimates are in line with consensus and, if the numbers come in at exactly these levels, market reactions should be muted. However, a miss on either side could further alter expectations on the timing of a first Fed rate cut.
Other data due out this week include retail sales on Wednesday, which we expect to show some downshift in consumer momentum at the start of the second quarter. Conversely, housing starts, due out on Thursday, should see a bounce back following weak March readings.
April numbers and the fiscal 2024 deficit
Last Friday saw the release of the Monthly Treasury Statement for April 2024. This is the most important packet of information we get on the federal budget during the year because of the unpredictability of annual payments and refunds around annual tax filing. With the April data in hand and only five months left in the fiscal year, (which ends on September 30th), we can get a better sense of where the budget is headed for the year.
As is usually the case in April, the Federal Government ran a surplus for the month. However, within the fiscal year, April stands out as an island of green in a deep sea of red. In February, the Congressional Budget Office, (or CBO for short), forecast a deficit of $1.507 trillion for this fiscal year. However, last week[1] they noted that, with extra costs from student and disaster loans and smaller-than-expected annual payments on individual and corporate taxes, they now expect this year’s federal budget deficit to exceed last year’s total of $1.695 trillion.
We concur and now project that the government will run a deficit of $1.708 trillion in fiscal 2024, or 6.0% of GDP. The primary deficit, that is the difference between revenues and outlays excluding net interest, should actually fall to $806 billion from $1.036 trillion last year. However, net interest costs could climb to $902 billion from $659 billion last year, mostly reflecting the increasing impact of higher interest rates, as the government refinances old debt and finances new borrowing.
This deficit, in an economy of slowing nominal GDP growth, could boost the debt-to-GDP ratio to 99.5% from 97.5% last year. In fiscal 2025, we expect the deficit to rise further, to roughly $2.068 trillion, or 7.0% of GDP, with net interest climbing to over $1.1 trillion and the debt-to-GDP ratio rising to over 102%.
Deficits and debt in the short run
In the short run, the deficit has more important implications for financial markets than the economy.
On the economy, we do not expect larger deficits to stimulate demand. This is because the primary deficit is actually relatively stable at close to 3% of GDP and has fallen since the pandemic and its immediate aftermath. It is growth in this primary deficit that really injects extra demand into the broad U.S. economy. Higher government interest payments, by contrast, largely end up in the hands of institutional investors, foreign governments and wealthy U.S. families and have a very limited impact on consumer spending or aggregate demand in general.
However, growing government borrowing does have some implications for financial markets.
In the 50 years before the Great Financial Crisis, 10-year Treasury yields averaged 2.7% above the year-over-year core CPI inflation rate. By that yardstick, even if core CPI inflation gradually falls, along with other inflation measures, to 2%, today’s 4.50% 10-year Treasury yield does not seem unreasonably high.
Moreover, the need to finance annual deficits that are heading above $2 trillion, combined with having to offset an annual $300 billion reduction in the Federal Reserve’s Treasury holdings should limit any rally in the long-end of the bond market, barring a major recession. These higher-for-longer long-term interest rates could also impede any decline in the dollar.
Deficits and debt in the medium term
The financial position of the federal government is likely to worsen further over the next decade. In February[2], the CBO projected that under current law, the federal government would run annual deficits of between 5% and 6.5% of GDP over the next decade, with the debt-to-GDP ratio rising to a record 116% by 2034.
This understates the likely deterioration in the public finances for two reasons.
First, as the CBO noted last week, their starting point, in terms of the deficit for fiscal 2024, appears to be too low. They will be publishing new 10-year projections in June which should show a higher baseline track for both deficits and debt.
Second, and more importantly, by convention, CBO forecasts assume a continuation of current law, which implies the expiration of many of the provisions of the 2017 tax cut in 2025. Regardless of who wins the presidency in November, we expect most of those tax cuts to be extended. CBO estimates of the cost of such a decision[3], added to its baseline forecast, imply that the debt-to-GDP ratio would rise to a record 127% of GDP by 2034.
While this track for federal debt is alarming, it probably doesn’t imply a debt crisis over the next few years for two reasons. First, as we have pointed out before, calendar 2023 represented almost the ultimate stress test for the U.S. Treasury market. In particular, the Treasury Department managed to raise enough money to finance a deficit of close to $1.8 trillion, add $364 billion to its short-term cash balances and offset a more than $700 billion reduction in Federal Reserve Treasury holdings and this was all achieved with the 10-year Treasury yield ending the year in exactly the same place as it started the year. This suggests a very strong underlying global demand for U.S. Treasuries.
Second, it needs to be recognized how much of the increase in annual interest payments on the debt merely reflects higher interest rates rather than the growth in the debt itself. If the economy were to go into recession or if, due to some crisis, the Federal Reserve decided to slash short-term interest rates and resume quantitative easing, this interest cost could fall very sharply.
Deficits and debt in the long run and investment implications
Having said all of this, the rise in the debt is important for long-term investors precisely because they are long-term investors. The biggest risk associated with federal debt is not excessive spending growth, insufficient tax revenues or even rising interest costs. It is that the political system is incapable of addressing the issue in a mature way. Even a cursory glance at this year’s federal budget, as we show on page 19 of our Guide to the Markets, makes it clear that no real progress on the deficit can be achieve without either cutting spending on defense, social security, Medicare, Medicaid or raising taxes or a mixture of all of these measures.
However, this has never been adequately explained to voters by either politicians or the news media and, consequently, voters have shown zero interest in electing politicians willing to make any of these tough choices. There is no sign that this will change and so the situation will very likely continue to deteriorate until some day, in five or ten or fifteen years when the debt can no longer be serviced within an environment of normal growth, normal inflation and normal interest rates.
At that point, there will only be two maneuvers available to a government still unwilling to make tough choices which could perhaps be labeled “The Argentinian Tailspin” and “The Japanese Coma”.
Under the first of these, the federal government and Federal Reserve could conspire to raise inflation to a level that significantly reduced the value of the debt relative to nominal GDP. The obvious problem with this is that interest rates would soar, worsening the debt financing problem while simultaneously crashing the economy and the currency.
Under the second strategy, the debt could still be financed if economic growth were suppressed to a point that held inflation and interest rates at very low levels as, for example, has been the case in Japan for much of the past 30 years. However, this would also have negative implications for economic growth and the dollar. Needless to say, both scenarios would also be very negative for returns on U.S. stocks and bonds.
This should, of course, have very clear implications for voters. However, assuming that our political system is incapable of producing reform before crisis, it also has investment implications.
The most obvious of these is international diversification. For all of its problems, Europe has actually been more responsible in dealing with its government finances than the U.S. Last year, the European Union collectively ran a budget deficit of 3.5% of GDP with government debt falling from 90% of GDP in 2020 to 82% of GDP last year. Both European bonds and European equities could be a port in a storm if there was eventually a U.S. debt crisis and the returns on these assets could be amplified by a rising euro relative to the dollar.
Other international diversification could also be helpful if it was directed towards countries with enough real economic growth to grow out of their debts. Real assets, such as investments in real estate and infrastructure, could also hold their value better in a debt crisis.
It should be stressed that the uncontrolled trajectory of the federal debt remains a long-term danger and may have little impact on investments in the next few months or even the next few years. However, the first step to successful long-term investing is to recognize that you are trying to maximize long-term returns while minimizing the impact of long-term risks and there are few long-term risks more ominous than our inability to limit the growth in federal debt.
[1] See Monthly Budget Review: April 2024, CBO, May 8th, 2024
[2] See The Budget and Economic Outlook: 2024 to 2034, CBO, February 7th, 2024
[3] See Budgetary Outcomes under Alternative Assumptions about Spending and Revenues, CBO, May 8th, 2024