Long term rates and debt evolutions, both in the US and in Europe
If markets are right about long real rates for US Treasury and European government securities, debt ratios will increase for some time. We must make sure that they do not explode.
Across advanced economies, the celebrated (r-g), i.e., the difference between the interest rate on public debt and the growth rate, appears to have durably changed sign or, at a minimum, to have gone from a substantially negative number to a number closer to zero.
It is fair to say that, while economists expected the short end of the yield curve to reflect the higher rates needed to win the fight against inflation, the sharply steeper long end of the yield curve in the last few months has come as a surprise. I shall freely admit that I did not predict it. (Neither did option markets, which, until recently, put a close to zero probability on long rates being what they are today.)
Even after the fact, it is still not clear what is behind this increase in long rates: Increases in the term premium, and if so why; unusually large flow supply and low flow demand due to quantitative tightening; a decrease in the proportion of price insensitive bond buyers, stronger sustained household demand; higher expected potential growth due to generative artificial intelligence? We do not really know.
Thus, it is not unreasonable to conclude that some of the underlying factors behind the recent increase are transitory and that long real rates will come down. Most of the factors that economists concluded had contributed to the long pre-COVID-19 decline do not appear to have turned around dramatically. But the fact is that long rates are high today, ministers of finance must finance themselves at those rates and cannot bet the house on such a decrease.
When (r-g) is equal to zero, the dynamics of the ratio of public debt to GDP become straightforward: If the government runs a primary deficit, the debt ratio increases. If it runs a surplus, it decreases. At this juncture, nearly all advanced economies are running primary deficits, many of them in the range of 2% to 4%. Thus, once current debt has been refinanced and the average interest on debt reflects the higher long rates, absent changes in policy, debt ratios will increase.
Put another way, stabilizing the debt ratio implies reducing primary deficits to zero. For both economic and political reasons, there is no way governments can do this quickly. A drastic, immediate consolidation would most likely be catastrophic, both economically in triggering a sharp recession, and politically, by increasing the share of votes going to populist parties.
So, how fast can advanced economy governments realistically consolidate? Some earlier policy measures, put in place to protect firms and households against COVID-19 disruptions and, more recently, large increases in the price of energy, can indeed be terminated, and this will help. This will however not be enough to close the deficits. More needs to be done.
The strong turn to fiscal austerity which took place from 2010 to 2014 in Europe, which is widely seen today as having been too quick, impeding the European recovery, should serve a cautionary tale. Add to this the additional spending due to the need to reinforce defense and increase public green spending. It is clear the adjustment must be steady but equally clear that it has to be slow. Starting from a 3% primary deficit, absent happy surprises, it may well take close to a decade to reach balance, and thus stabilize debt.
Achieving the required path of sustained fiscal consolidation will not be easy. For investors to believe in it and not ask for a higher spread, there has to be a credible plan, with specific measures either on the spending or the tax side to achieve it. But, even under such a scenario, the debt ratio will increase so long as primary deficits have not been eliminated.
Such an increase is inevitable (unless long interest rates decrease again, in which case we return to a world where debt stabilization allows for some primary deficits, and the adjustment can slow down or stop all together). It is not good, but it is not catastrophic. I have argued elsewhere the evidence suggests that advanced economies can sustain a higher debt ratio, so long as it is not exploding.
What must indeed be avoided at all costs is debt explosion, which would be the case if primary deficits just did not go away. Thus, putting the previous arguments together, the right plan is a credible plan of steady primary deficit reduction, but accepting the fact that the debt ratio will increase for some time, and stabilize at a higher level. And, here, I see divergent paths for the European Union and for the US.
Central to the evolution of debt in the European Union is how the revised EU fiscal rules will look like when they are finally adopted. What is being discussed, namely the assessment of debt sustainability using a common methodology but recognizing that each country is different, represents major progress relative to the overcomplicated Tinguely contraption that previous rules had become. It may be however that the new rules will be too tight to allow for the slow and steady adjustment described above, and this is cause for worry.
In any case, I have little doubt that we shall see fiscal consolidation in Europe over the coming years. One interesting implication is what happens to European interest rates. It is not implausible that fiscal consolidation, combined with sustained weak private demand, leads to the need for the European Central Bank to decrease rates once it has won the fight against inflation. Paradoxically, high rates today may portend low rates in the future. If so, this will improve debt dynamics and make the adjustment easier.
The situation is quite different and more worrisome in the US. Long term real interest rates are higher than in Europe, and the primary deficit is between 4% and 5%. At the same time, the current budget process is simply dysfunctional. The debt ratio is on an exploding path and it seems unlikely that the adjustment will be smooth. It may take some form of crisis, say a failed auction or the emergence of credit spreads on Treasuries, to trigger the required turnaround. One can even think of more worrisome scenarios, for example the election of Donald Trump and the subsequent appointment at the Federal Reserve of a Chair willing to inflate away the debt. Needless to say, this would have major implications, not just for the US, but for the world. We have to hope for the best but be ready to explore more pessimistic scenarios.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the those of AXA Investment Managers.