An albatross around Donald's neck
To have an albatross around the neck means metaphorically a burden that is difficult to escape, or a source of difficulty that hinders one's success : it feels like a curse
Reviews outlining the impact of the latest U.S. Federal Budget - marketed as big (which it is) and beautiful (which is in the eye of the beholder) - sidestep the reality of deficits and inherited debt of previous budgets
This is a follow-up note of U.S. Treasuries Yield Curve - Reading the runes which highlighted the fast-growing federal debt load, bringing on increased interest rates, and pushing interest expense upward to 25% of federal tax income
At the end of 2024, according to the Congressional Budget Office (CBO) Budget and Economic Outlook 2025-2035, published in January 2025, debt held by the public amounted to $28.2 trillion (97.8% of GDP)
Projected deficits over the coming decade average at $2 trillion per year, before accounting for the recently adopted budgetary measures
- In this framework, debt was expected to rise to $52 trillion by 2035 - equivalent to an estimated 118.5% of GDP
- In 2025, debt of $30 trillion will weigh approx. 5.8x the fiscal revenue of more than $5 trillion
- In 2035, the $52 trillion anticipated debt - as estimated by the CBO - would weigh 6.5x the anticipated revenue of $8 trillion
That was then....
CBO adjusted its mid-year 2024 10-year deficit projections downward by $1 trillion in its January '25 reappraisal, due to economic changes, particularly increases in projected revenues from individual income taxes
This is now....
The impact of the additional deficits resulting from the Trump Administration's budget bill over the 10-year timeframe is uncertain but most of the $4 trillion new debt is expected to be front-loaded, on top of the current debt, while reductions in budgetary outlays will be accounted for after 2026
The trend is unmistakable : the federal debt has been growing faster than GDP
- Debt was equivalent to an average of 50% of GDP over the last 50 years (1975-2024) - in 2025, it will be 100% of GDP and 118% in 2035 (by CBOs January estimate) or 130% (according to Bridgewater founder Ray Dalio and to Bloomberg Economics, taking the latest budgetary measures in account)
- More and more additional debt has been generating less and less additional growth
Interest costs are the albatross
CBO economic projections - admittedly hard to establish over the long term - are assumed to remain mostly benign with subdued inflation (2%) and steady real growth (1.8%)
Under this scenario, a federal funds interest rate drop of more than 1% to 3.3% could be envisioned
The interest cost in 2035 would be very large at $1.7 trillion ($1.25 trillion projected for 2025) although lower as a % of fiscal revenues (21% instead of 25% in 2025)
But are the "Goldilocks" credible ? or wil the prospect of a recession bring yields down ?
Bond rebellion...
The growth of U.S. public debt, resulting from a $2 trillion gap between 2025 fiscal revenues ($5 trillion in 2025) and outlays ($7 trillion), and for every year going forward, will weigh on projected annual interest costs
According to the January CBO forecasts, interest cost was expected to rise to $1.7 trillion on the $52 trillion debt estimate in 2035 (based on an interest rate of 3.3%)
- Though huge, this would signal an increase in interest cost of just 36% over 2015 estimates
- However, the debt itself would grow by 73% over the same timeframe, from $30 trillion to $52 trillion
At first glance improbable, the implied squeeze on interests assumes a benign long-term growth trajectory (1.8% in inflation-adjusted real terms) under the cloud of a giant, and growing, debt load
Setting the impact of the new Big Bill apart, the massive stock of debt to be financed, totaling more than $10 trillion this current year alone (including refinancing of one third of current debt in 2025 and the budget shortfall of $2 trillion, anticipated by CBO in January) do not leave much room for falling yields
It is a matter of time before bond investors rebel, reclaiming higher, not lower, yields across the yield curve, bringing down the card house of debt that Mr. Trump and his predecessors built
Longer maturity rates will be monitored closely if (when ?) the Fed starts lowering the target rate
At the short end of the yield curve, actual demand (driven in large part by the money markets) and the Fed's open market operations will determine the short-maturity T-bill sales, expected to be large
However, demand of longer dated bonds, where yield increases would potentially pressure consumer credit and business loans in interest-sensitive sectors, appears to be the deciding factor
Plainly stated, talk about lower rates by the U.S. Administration is cheap but who will buy the bonds (and carry the risky exposure long-term) ?
Japan, a model for the ages ?
Troubled by overwhelming debt levels and falling growth prospects, crowding out private investment, Japan (2013) has faced a comparable conundrum
In pre-nomination interviews, Secretary of the Treasury in waiting Scott Bessent outlined a “3-3-3” plan – loosely based on the “Three Arrows” concept of former Japanese Prime Minister Shinzo Abe
- In essence, this plan would strive for 3% GDP growth through deregulation and stimulated private investment, a 3% of GDP target for U.S. fiscal deficits through sharp cuts in federal spending, and a 3 million barrel per day increase in U.S. oil production
- The original Three Arrows scheme to lift the country out of its funk, combined aggressive monetary easing, flexible fiscal policy, and a growth strategy including structural reforms
As a firewall to cope with a market-driven meltdown, the suggested policy is two-pronged
- Forceful domestic investment to support GDP growth, which, in Mr. Besssent's thinking, is paired with deficit reduction (by way of increased fiscal revenues)
- Cautious yield curve management, which, while studiously ignored in Mr. Bessent's comments, is very probably part of the agenda
A study by the Federal Reserve Bank of St Louis, published in March 2025, provides context to the Japanese scheme
- Exposure to a governmental and local debt exceeding 220% of the country's nominal GDP, the highest of any advanced countries, is not all it appears to be
- While government debts can arguably be run indefinitely if the real growth rate of the economy exceeds the real yield on government debt, this has not been the case in Japan since 1997
- Building up debt year after year (running deficits of more than 5% every year), the country should be in the grip of a debt crisis and is not
The authors of the study make two key assumptions which highlight the singularity of Japan's monetary policy
- "The Bank of Japan has undertaken a huge expansion of its balance sheet with short-term liabilities funding long-term and even risky assets, thus earning a significant excess return.
- This expansion blurs the line between the Bank of Japan (BoJ) and public financial institutions."
By expanding simultaneously the debt side by borrowing massively short-term in the market and the asset side of the equation by investing long-term in equities, domestic but also foreign, the government realized excess returns estimated at 4.66% per year since 2012
- On the debt side, low borrowing rates resulted from Quantitative Easing (QE), financial regulation and low financial literacy of the Japanese investors...
- On supply side, returns were boosted by foreign equities and unhedged currency exposure...putting a falling Japanese Yen at the center of the favorable equation
Thinking the unthinkable
To avoid being overwhelmed by public debt, governments have just two levers - by firing-up economic growth or by engineering financial repression (interfering in bond supply & demand price setting)
- Budgetary stimulations to GDP growth, which might contribute to increase tax revenues (and reduce debt) seem counter-intuitive, because it may feed inflation and drive interest rates up (not down)
- A drop of interest rates by 1% (or much more) all along the yield curve assumes strong demand for bonds and requires, potentially, a degree of financial repression
Growth, downward shifting yield curves and subdued inflation seem impossible to reconcile
The intractability of the issue, in its financial and economic dimensions, has put a shine on Japan's experience in management of huge public liabilities
Lessons - if any - would be rule breaking, as Mr. Bessent, former hedge fund manager at Soros Fund Management and familiar with Japan's 2013 policies, surely knows
- The Japanese government managed public liabilities in isolation, disengaged with international markets and in close coordination with the Bank of Japan and the financial institutions
- Massive floating short-term public debt was 'force-fed' to retail investors with limited expertise or alternatives
- A risky 'carry trade' - borrowing at low rates domestically and investing for high returns internationally (mainly on U.S markets) was put in practice by the government to great benefit and supported by U.S. asset managers at scale (estimated at $880 billion in early 2024 by the Bank for International Settlements)
Follow-through by drawing on the Japanese model remains hard to conceive
With cascading pressure on the dollar system, linked to Mr. Trump’s relentless pressure on the Federal Reserve’s independence, unconventional scenarios could become very real
The most extreme policies would entail a degree of isolation, refocused on the U.S. domestic market
Debt restructuring by conversion of longer-term debt - especially debt held by foreign entities - into other instruments such as ultra-long, zero-coupon bonds has been strenuously denied by its architect, economist Stephen Miran, current chair of the Council of Economic Advisors, but could be revisited any time
Foreign investment mandates, imposed by hook or by crook, linked to attractive tariff terms, and very much in line with the Administration's operating mode, appear all but certain
How the dollar would withstand such unconventional musings will be discussed in our follow-up note 'U.S. Dollar - Unblinking in times of uncertainty ?'