One of my Diligence Wealth Club members asked:
“As the US Treasury’s debt problem grows, it is stepping up its intervention in the bond market. In the scenario where government borrowing goes up, and AI infrastructure investment (investment-grade (IG) borrowing) rises at the same time, which we are seeing now, there will be more competition for investor money.
The required return could rise further. It’d be interesting to see how this pans out for the equity markets. Willie, with your past experience in the bond markets, can you share, from your perspective, how you see this scenario might play out?”
It’s a very good question. And I thought I want to share with my readers today.
First, while the Fed controls the short-term interest rates, long-term interest rates are driven by market forces – central banks, fund managers, banks, etc.
These institutions react to what’s going on in the world: a massive surge in AI-related borrowings, ballooning government deficits, and the threat of higher inflation from an ongoing war.
This makes long-term interest rates very sensitive. That’s why we’re seeing high long-term yields.
Normally, this isn’t a problem. The Fed can print more money to buy back long-term Treasury bonds. This artificially keeps interest rates under control. It works very well when a country has a low public debt, which allows the government to easily service their interest costs on its debt.
Pretty much what happened during the 1940s, when the US was even able to reduce its debt relative to the size of its economy.
However, today things are different. The US now holds a far larger amount of debt relative to its economy.,
The US economy now sits on a whopping $40 trillion of national debt (including public debt). When an economy has an enormous debt load, the Fed needs to aggressively buy back bonds to move the needle.
This has a lasting impact on the economy – a surge in money growth chases that few goods and services, resulting in consumers facing the threat of rising inflation. The Fed is stuck in a position to raise short-term interest rates to fight against inflation.
It can be frustrating. You see, when a country’s debt-to-GDP is significant, its government needs to pay a far larger interest cost even with a small rise in interest rates. That’s what’s happening in the US economy today.
Of course, this can be solved if the US economy grows fast enough to potentially pay down any rise in interest costs because the debt burden becomes a smaller share of the GDP.
In other words, it used to be that the US could grow its way out of its debt. But not anymore. Since the 2000s, US fiscal deficits have been rising over time with fiscal spending (including interest costs) outpacing the government’s revenues.
Growing out of its debt is getting harder and harder.
This becomes a dangerous cycle.
Left unchecked, this is how the sovereign debt crisis takes shape: currencies weaken, inflation rises, and asset prices swing wildly. Consumers end up paying more in interest on their big purchases like cars, homes and even daily necessities. Spending gets cut back, and the economy slows down.
At this point, I’m bearish on the bond market. I believe this debt cycle will continue for as long as uncertainties around AI-related borrowings, and the ongoing war keeps on going. Remember in my earlier email newsletter on how the stock market is influenced by short-term interest rates? That’s what will happen.
As an investor, my job is not to predict what Mr. Market is doing. Instead, start buying value, don’t pile up leverage, and stay patient. My take is to start looking at stock opportunities in high-quality businesses that could continue to raise prices in the midst of inflation – strong branding power.
Sometimes, investing can be simple.
Willie Keng, CFA
Founder, Dividend Titan
