The yield on ten-year U.S. Treasuries is up over 400% in the last eighteen months. That is off a very low base: yields troughed at 0.5% in March of 2020 and now stand at around 2.7%. With such a big move in such an important macro-economic variable, investors should ask: who will get hurt the most from higher long-term interest rates? Where do the hidden risks lie?
To answer those questions, we look no further than the U.S. Federal Government, the largest issuer of U.S. dollar debt by a large margin. Here are some debt and spending metrics for the U.S. Government for 2021 compared with 2000:
The finances of the U.S. Government have eroded materially over the last two decades. In 2000, the U.S. Government had no deficit and outstanding debt of just 33% of GDP. Today, it runs a $3 trillion deficit and has debt equal to nearly 100% of GDP. Not only has its balance sheet deteriorated materially relative to its ability to repay, but it continues to spend far in excess of its revenues.
We believe the U.S. Federal Government has become complacent about its spending and financial situation. The declining interest rate environment has facilitated that complacency. While debt outstanding has increased 6.4x since 2000 ($3.4 trillion to $22.3 trillion), interest on that debt has increased just 1.7x and interest expense as a percent of GDP has actually fallen from 2.3% to 1.7%. Increasing debt manifold while reducing debt service costs as a percent of GDP is made possible only by a continually declining interest rate. The falling interest rate environment, in short, has allowed the U.S. Federal Government to spend far in excess of revenues with no real cost ramifications.
That happy situation has now changed. Debt service costs will begin eating up a bigger and bigger percentage of GDP as the U.S. Government begins refinancing its existing pile of debt as it comes due.
In the meantime, deficit spending continues with no end in sight. Those deficits will require incremental new debt, which will add to the debt service obligation over and above the effect of higher rates on the existing debt.
In addition, none of these numbers includes the deficits associated with the U.S. Medicare and Social Security programs. Some, including the U.S. Treasury itself, say the present value of those programs is negative $71 trillion, dwarfing all other liabilities of the U.S. Government combined. Net cash flows from those programs until recently have been positive or breakeven, but will soon turn sharply negative. Those programs will either need to be restructured or their deficits somehow funded.
Our guess is the U.S. Government won’t deal with the funding obligation associated with these two government programs until it becomes a pressing problem. If we’re right, the U.S. Government will somehow have to fund growing deficits associated with Medicare and Social Security. That would be over and above the increased debt service requirements associated with higher interest rates on existing debt as well as the increased debt service requirements for incremental new debt to fund ongoing run-of-the-mill deficits.
To say the U.S. Federal Government will face some fiscal challenges in the months and years ahead is in all likelihood a big understatement. Its financial position has eroded materially over the last few decades and will continue to erode in the months and years ahead, in our view.
The U.S. Dollar a safe haven? We don’t see it.
As investors, we are limiting our exposure to the U.S. Federal Government and, by extension, the U.S. dollar.
