The inversion of the yield curve has prompted concerns the US economy is on the brink of a recession. But investors should be more worried about the potential lasting effects from a continued deterioration of the country’s public finances over the next decade, says James McAlevey.
6 minute read
The inflection point. The critical mass. The market pivot. Investors are constantly on the lookout for indicators of an impending shift. Recognising pertinent signals – and their potential impact on asset prices – is crucial to good investment decisions.
This helps explain the fevered commentary surrounding the so-called inverted yield curve in 2019. In August, yields on two-year US Treasuries ticked higher than those on 10-year bonds for the first time since 2017, prompting fears the US economy is set for a slump.
Yield-curve inversions have preceded the last five periods of negative growth in the US
Such concerns are understandable: yield-curve inversions have preceded the last five periods of negative growth in the US. But that does not mean a downturn is imminent this time around. Inversions do not always predict recessions. It is statistically impossible for a single metric to reliably indicate the direction of such a vast and complex economy; other variables are always in play.
One salient fact is that the term premium – the extra yield investors demand to hold long-term assets over short-term ones – has collapsed in recent years, partly in response to external factors such as low yields in other global markets, which have spurred capital flows into US Treasuries. When the term premium is low, the yield curve may invert even if the likelihood of recession is unchanged. Moreover, central banks’ massive quantitative easing (QE) interventions over the last decade may have impaired the yield curve’s capacity to send accurate economic signals.
The term premium has collapsed in recent years, partly in response to external factors such as low yields in other global markets
In October, the yield curve steepened, easing fears of a downturn. But this does not mean all is right with the US economy. As we enter 2020, the budget deficit is growing wider and the federal debt pile ever larger. The deterioration of the US public finances, along with the associated market and economic effects, could become a key theme of the next ten years.
Jobs and the deficit
For an indication of the potential trouble ahead, look at Figure 1, below. It shows a correlation between the US budget deficit and the US unemployment rate since the end of the Second World War. When more people are in work, the budget deficit tends to fall.
Figure 1: The relationship between the US deficit and the unemployment rate has broken down
This correlation makes intuitive sense; when the economy is ticking along the government tends to enjoy higher tax revenues and spend less on unemployment payments and other benefits. When the economy is struggling, the reverse is true: in the aftermath of the global financial crisis of 2008-’09, the budget deficit and unemployment spiked in tandem. The only exceptions to this rule were brief periods in the early 1950s and the mid-1960s, when the government was spending heavily on wars in Korea and Vietnam, respectively, even as unemployment was relatively low.
The deficit has risen for four years running – the first time that has happened since the early 1980s
However, as the chart shows, the correlation between unemployment and the deficit is breaking down again – an unprecedented turn of events in peacetime. The chief driver of this trend is the current administration’s pro-cyclical fiscal policy. Under President Trump, the US has cut taxes and increased spending even as the economy purrs and joblessness falls. The deficit has grown nearly 50 per cent since the 2016 election.
According to US Treasury figures, the deficit had risen to $984 billion, or 4.6 per cent of GDP, by the end of September. This is the highest it has been since 2012, a time when unemployment stood at seven per cent, more than twice its current level. The gap between spending and revenue has grown by 26 per cent, or $205 billion, since September 2018. The deficit has risen for four years running – the first time that has happened since the early 1980s – and is likely to surpass $1 trillion in 2020.
President Trump regularly takes to Twitter to proclaim the strength of the US economy as stock markets hit new highs. References to the country’s surging debt pile, however, are less common. Yet if current fiscal policy is maintained, overall debt could climb to record levels. Under its baseline scenario, the Congressional Budget Office (CBO), a nonpartisan organisation that analyses US government finances, projects overall debt would rise from 78 per cent of GDP at the end of 2019 to 144 per cent by 2050 – far in excess of the previous peak of around 120 per cent during World War II (see Figure 2).1
Current policies would push annual federal spending up from 20.7 per cent of GDP in 2019 to 28.2 per cent by 2049, partly due to increased mandatory outlays on healthcare. As the population ages, per-capita costs for government-funded Medicare and other healthcare programmes are rising (see Figure 3).
Figure 2: Public debt projections under continuation of current fiscal policy
Figure 3: Entitlement spending under current policies/demographic projections
With an election looming, the current administration is unlikely to cut spending or reverse tax cuts in the short term. And many of the Democratic Party politicians jostling to face Trump in 2020 have pledged to expand healthcare coverage even further if they take office.
Medicare-for-All would increase federal healthcare costs by $34 trillion in its first decade
The Urban Institute, a centre-left think tank, calculates that Medicare-for-All, the single-payer healthcare system advocated by several leading Democrats – including the front-runner ahead of the party primary, Elizabeth Warren – would increase federal healthcare costs by $34 trillion in its first decade. This is more than the CBO’s estimate of the total cost of social security, Medicare and Medicaid combined over that period.2 According to the Committee for a Responsible Federal Budget (CRFB), a bipartisan organisation, such an outlay would require either a 32 per cent payroll tax, a 42 per cent value-added tax, an 80 per cent reduction in non-health federal spending; or a rise in the national debt equivalent to 108 per cent of GDP.3
Even if Democrats moderate these proposals, the prospects for structural reform to tackle the rising costs of the existing system look remote. In sharp contrast to the Obama administration, which agreed a plan with Republicans in Congress to reduce the deficit in the post-crisis period, there is currently little appetite to trim the debt load.
We could be entering a 'new normal' – an era in which deficits continue to grow even as the economy expands
In July, Republicans and Democrats struck a deal to raise the so-called debt ceiling until 2021, beyond the previously stipulated $22 trillion limit. Given that the political consensus favours further spending increases, the ceiling could well be lifted again when the time comes. We could be entering a “new normal” – an era in which deficits continue to grow even as the economy expands.
The next recession
Why worry about debt? The US government has spent $376 billion on interest payments on Treasury bonds in the fiscal year to date, more than its total spending on education and transport combined (see Figure 4). But yields on Treasuries remain low and such payments are relatively affordable in historic terms. There is a case to be made that the US should take advantage by borrowing to invest in much-needed infrastructure to improve the long-term productive capacity of the economy. There are reports the US is considering “locking-in” low interest rates by issuing a 50-year Treasury bond.4
As older people tend to save more and borrow less, an ageing population results in higher savings rates
Dovish commentators argue the same demographic trends that are pushing up healthcare costs are also anchoring interest rates, making large debts less of a problem. As older people tend to save more and borrow less, an ageing population results in higher savings rates, lower demand for credit and a lower cost of borrowing. In Japan, the fastest-ageing country in the world, public debt remains eminently serviceable despite standing at nearly 250 per cent of GDP. Investors are even willing to pay the Japanese government for the privilege of lending it yet more money, with the benchmark 10-year bond in demand despite a negative yield.
Figure 4: Breakdown of US federal receipts and spending, fiscal year 2019
Given the dominance of the US economy – and the dollar’s status as the world’s reserve currency – demand for Treasuries should likewise remain robust even if debt escalates to Japanese levels. This is the view of analysts at Goldman Sachs, who argued in a 2018 report that “Japan’s experience confirms a debt crisis is difficult to imagine in a country that issues debt in its own currency, has a flexible exchange rate and controls its central bank,” although the report also conceded that the home bias of Japanese investors – a point of contrast with the US, which sells most of its debt abroad – is a factor in keeping yields so low.5
Economies that can cut interest rates and unleash budgetary spending during economic downturns recover much more quickly than those that can’t
However, this analysis overlooks the challenges large deficits present in adverse economic scenarios. A recent study by academics at the University of California, Berkeley, indicates the degree of monetary and fiscal “space” prior to a period of financial distress – that is, whether the policy interest rate is below the zero lower bound, and whether the debt-to-GDP ratio is manageable – has a significant impact on economic performance in the aftermath of crises.
When a country has both types of policy space, the decline in output following a crisis is less than one percent; when it has neither, the decline is almost ten per cent.6 Simply put, economies that can cut interest rates and unleash budgetary spending during economic downturns recover much more quickly than those that can’t.
The US still has some space left in monetary terms, despite the Federal Reserve’s three rate cuts in 2019. But with the deficit rising, the government has much less room for manoeuvre on fiscal policy. Even if investors are happy to continue lending to the US at low rates of interest, history shows political consensus can quickly evaporate at times of crisis, limiting the ability of the government to implement fiscal stimulus.
One implication of this trend is that the fate of advanced economies could well diverge in the aftermath of the next global recession. Compare the US with Germany (see Figure 4). With its healthy surplus, Germany should have the fiscal ammunition to mitigate the impact of a downturn if the Bundestag were to countenance such a move.
Given the trajectory of the deficit and the scale of its looming entitlement liabilities, the situation in the US is more uncertain. Perhaps the dovish projections are correct, and the American government can keep borrowing ad infinitum with no negative consequences. But this would be a dangerous proposition to put to the test during a recession.
Figure 5: Fiscal room for manoeuvre varies between countries
- 'An Update to the Budget and Economic Outlook: 2019-2029', Congressional Budget Office (CBO), 21 August 2019
- Linda J. Blumberg, John Holahan, Matthew Buettgens, Anuj Gangopadhyaya, Bowen Garrett, Adele Shartzer, Michael Simpson, Robin Wang, Melissa M. Favreault, and Diane Arnos, ‘From Incremental to Comprehensive Health Reform: How Various Reform Options Compare on Coverage and Costs’, Urban Institute, October 2019
- ‘Choices for financing Medicare for All: a preliminary analysis’, Committee for a Responsible Federal Budget, 28 October 2019
- Colby Smith and Tommy Stubbington, ‘US Treasury considers selling 50-year bonds’, Financial Times, 30 October 2019
- Dan Struyven and David Mericle, Goldman Sachs, 2018
- Christina D. Romer and David H. Romer, ‘Why some times are different: macroeconomic policy and the aftermath of financial crisis’, University of California, Berkeley, October 2017