Massive government borrowing during the Covid crisis means high government deficits will take the ratio of government debt to GDP well above 100% in both the US and UK. We project ratios of 123% and 108% respectively by 2022. These projections assume we have a vaccine in 2021 so that social distancing is no longer necessary and the economy can fully recover. If a vaccine takes longer, or proves elusive, deficits could be higher for longer, pushing debt ratios higher.
Why higher debt will not raise rates
In the past high debt ratios were viewed as risky for bond holders because they could lead to higher interest rates as supply overwhelmed demand. This would in turn damage the economy because high rates could crowd out investment and slow GDP growth. Many studies in the past have suggested that countries with higher government debt grow more slowly, though it must be admitted that there is controversy over the size of the effect and even the direction of causation.
But interest rates are structurally low today because of ‘excess savings’ and high demand for risk-free assets. It seems implausible that business investment will be choked off by government borrowing. Pension funds, insurance companies and banks are still eager buyer of bonds even at very low yields, indeed negative in real terms. Of course, central banks are buying too. QE does not change the aggregate of public sector debt – it merely shifts it from longer-term maturities to overnight reserves. But it does reduce the supply of those longer-term bonds in the market, holding down long-term interest rates.
Don’t expect aggressive austerity in the 2020s
In the last cycle, both the US and British governments worked hard to control spending and bring down deficits, especially from 2010-17. Although interest rates were kept low and quantitative easing was employed to help offset the drag on the economy from fiscal tightening, growth was likely restrained. In the upswing now underway governments are likely to simply accept high debt ratios and not be so aggressive in trying to reduce deficits. This change compared with the last cycle will support economic growth in coming years.
Governments will be helped by central banks keeping interest rates low, making funding costs for the extra debt very modest. At current funding rates (less than 0.5%) the extra government interest bill from the Covid surge in debt is very small. Even if interest rates return to 2.5%, the extra borrowing we project in 2020-21 will add only about 1% of GDP in interest payments to the government’s burden. This is not insignificant, especially given long-term concerns about fiscal sustainability from population ageing, but it is not crippling. Moreover, for interest rates to return to 2.5%, the economy will need to be motoring with inflation back at 2%, so the denominator of the debt/GDP ratio will be rising briskly.
Inflating away the debt is unlikely
A deliberate policy of ‘inflating away’ the debt is unlikely partly because central banks still have independence but also because it is hard to achieve. The effective maturity of debt is shorter than it appears because of quantitative easing and index-linked debt. But if interest rates are kept low, the risk is that inflation goes higher in future years. The Fed’s shift to targeting the average inflation rate gives them leeway to accept inflation above 2% in coming years since if US inflation had been 2% pa since 2007, the price level should be 10% higher. We doubt whether the Fed will try to catch up on all of this but it certainly gives them a reason for remaining ultra-dovish. The Bank of England has met its 2% target on average over the last 10 years so does not have the same leeway. That said, it is likely to remain ultra-dovish for some years which means that real interest rates, including yields on bonds are likely to remain negative.
So, will debt ratios come down? The Covid crisis is set to raise the UK's net debt ratio to the highest level since the 1960s. Paradoxically, it is easier to bring debt down when the ratio is higher than when it is lower. For example, at 100% of GDP, with 4% annual nominal GDP growth, bringing the ratio down requires the budget deficit to be less than 4% of GDP. At a debt ratio of 150% of GDP, the deficit only needs to be lower than 6% of GDP for the ratio to fall. Of course, there is more interest to pay at the higher debt ratio. But if the interest rate is low, governments may still actually have to more to spend at the high debt ratio (i.e. after paying interest).
Implications for investors
First, the ‘Covid surge’ in government debt is not in itself a threat to stocks. Markets can anticipate a long-lived economic upswing (after Covid) without the risk of hawkish fiscal or monetary policy to deal with high debt.
Secondly, high government debt is not a threat to bonds either. It will not in itself push up yields in the current environment because there is ample demand for safe assets.
Thirdly we expect inflation to return to 2% or higher so the long-term bond investor will lose value in real terms with real yields so low currently.
The case for holding bonds then is two-fold. First, there is a chance that the economy could stall in coming months, perhaps due to a strong resurgence in Covid or disappointing failures with vaccines. This would take bond yields lower still, or into negative territory. The associated rise in bond prices would help to limit the damage to portfolios if (as is very possible) stock prices fell at the same time. Secondly, if we are wrong and the US or UK experience deflation in coming years, following in the path of Japan, then as well as new capital gains as yields fall, long-term investors buying today, might be happy even with current sub-1% coupons. Given deflation, deposit rates could be zero or even negative for many years.
Any impact on currencies? If investors start to worry about high debt in the US or UK this would likely show up in a weaker currency. We do not expect that near term, as long as debt is stabilised by 2022-3. But if worries about higher inflation increase, the pound and dollar could weaken.
John Calverley, Chief Economist