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US Debt Crisis: 3 Pathways To Regain Economic Stability

The U.S. has a debt problem. The relatively peaceful globalized prosperity, which lasted for decades, might end.  In such an increasingly fragmented environment, the demand for U.S. government debt is slowing while its size keeps growing.

Per Economics 101, reduced demand typically drives up prices, meaning the government must take on more costly debt and offer higher yields.

As yields rise, they become an attractive alternative to lock in a safe return compared to the volatile stock market. Despite the S&P 500 returning 18% YTD, this performance comes from a handful of mega-cap stocks, as its equal-weight counterpart has a return of 2.72%.

A straightforward calculation can illustrate this point. When you divide 1 (representing one year) by the forward price-to-earnings (P/E) ratio, you arrive at an estimate of expected growth in the equity market based on anticipated earnings. For example, 1 divided by 20.45 gives 0.049, or 4.89%.

This figure indicates a negative equity risk premium. It implies that investors who choose to invest in the S&P 500 now are essentially forfeiting a 0.36% return they could have gained by investing in a 1-year bond instead.

Therefore, there are only three possible scenarios through which this situation can be resolved.

1)    Earnings end up being much better than anticipated

The Conference Board predicts U.S. GDP growth of 0.8% in 2024, including a “shallow recession” in the first half of the year. While the recession is questionable given the recent GDP growth, a drastic outperformance would still be surprising.

Also Read: Will Microsoft’s Hire Of Sam Altman Accelerate Generative AI? 3 Analysts On Satya Nadella’s Power Move

2)    Bond yields go down

Bond auctions have been a canary in the coal mine. At October’s 30-year auction, broker-dealers had to absorb 18% of the sales. At the latest auction on Nov. 9, this number rose to 24.7%, more than double last year’s average of 12%.

The government had to offer 5.1 basis points (0.051%) higher than pre-auction trading to entice investors with a premium.

U.S. government bonds have been a risk-free yield standard for years. Thus, they serve as a baseline comparison point for numerous other investments, most notably equities.

3)    Equities become cheaper

If equities become cheaper, then they will offer a positive risk premium. This scenario doesn’t mean a market crash but rather a “healthy” downward correction.

Yet, in the past, these corrections usually had some kind of catalyst – for example, the volatility explosion in February 2018. Furthermore, these corrections were seldom orderly. An old Wall Street proverb says that the market takes stairs up but an elevator down.

At these valuations, it is unsurprising to see value investors like Buffett hold $157 billion in cash or go as far as Japan to find attractive investments, as he did in 2020.

Cracks In The Credibility Shield

In a recent Wall Street Journal opinion piece, former World Bank president David Malpass wrote that “to guard its credibility and independence, the Fed needs to speak out on fiscal profligacy as Paul Volcker and Alan Greenspan did.”

Malpass also called for a faster reduction of the Fed’s balance sheet, which is currently about 60 billion per month. Mechanically, the FED does this by not reinvesting the funds it receives from maturing securities, a tactic known as a portfolio runoff.

However, this quantitative tightening (QT) maneuver is limited by the quantity of securities maturing during any given month. If the Fed decides to sell securities before their mature date, it risks putting further pressure on yields.

Experts, including Citadel’s Ken Griffin and Richmond Fed Chief Thomas Barkin, have warned that tempering the 2% inflation target by cutting too soon would damage the Fed’s credibility. The yield curve inversion since June 2022 has been the longest-lasting since 1980. Still, the inversion is a typical sign of the restrictive monetary policy. The shift in the yield curve does not indicate that the economy is now at less risk of a recession. If anything, it could tighten the financial conditions further.

Now read: Legendary Economist Foresees 30% Drop In Stocks, Predicts Recession And Fed’s ‘Credibility’ Issue

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