August 14, 2023 ~ Fitch downgraded US debt from to AA+ from AAA, citing poor fiscal controls and out of control spending. Most investors were aware of the US government’s fiscal irresponsibility so this downgrade was not much of a shock, but some forecasters are now predicting much higher US treasury bond rates partly due to the current fiscal situation and the Fitch downgrade.
US External Debt to Investors vs Total US Government Debt:
It is important to distinguish between total US government debt outstanding and the net US external debt to investors. The Federal Reserve did monetize a good portion of the excessive Pandemic relief spending, which limited the growth of US external debt, but of course also produced the worst inflation since the 1970’s. The current US external debt is approximately $25 trillion vs. the gross debt of $31.5 trillion. Nominal GDPT as of the end of the second quarter of 2023 was $26.8 trillion so total external debt is 95% of GDP.
Federal Budget Deficit vs GDP:
The Federal budget deficit is projected to be $1.4 trillion for the fiscal year ended September 2023. This represents 5.2% of nominal GDP. US nominal GDP growth has averaged just over 6% since WWII. Even if average GDP growth slows to just over 5%, the ratio of external debt to GDP will be stable at approximately 1x GDP. This level of debt and deficits is suboptimal for economic growth as government deficit spending crowds out private investment and, therefore, slows US economic growth. However, given the strength and diversity of the US economy, including being the dominant source of most cutting-edge technology, this level of debt is manageable. Consequently, we
Do not believe that US federal deficits will contribute to significant increases in US long term interest rates and
We are still forecasting that 10-year treasury bond rates will fall to the 3%-3.25% area as:
Inflation continues to subside,
Central bank rate increases pause and
Global growth slows in response to the global tightening of monetary policy over the last year.
In addition, there is over $50 trillion of global pension assets, much of which is under-allocated to bonds.
Finally, US interest rates are high relative to other global government bond rates, with German Bunds being 150bp below US rates, French bonds being 100bp below US rates and Canadian bonds being 50bp below the current US rate of 4.15%.
If long term bond rates fall from today’s elevated rate, that is likely to spur a 4th quarter rally in stocks as long term interest rates are a key determinant of sustainable stock market earnings multiples.