Rising US debt and yields threaten global growth, will keep market on edge

Jamie Dimon, chief executive officer of JPMorgan Chase, the world’s largest bank by market capitalisation, recently warned that a crack in the US bond market was imminent. Undoubtedly, the prediction is dire, and if it comes true, the consequences for financial markets and the global economy could be severe. The US has the largest and most liquid government debt market in the world. Since global financial markets are deeply interconnected and interdependent, a dislocation in the US debt market can impact practically every financial asset across the world, with significant implications for the real economy.

 

The yield on the 30-year US government bond recently crossed the psychological 5 per cent mark. The yield on 10-year US government bonds has also inched up, underscoring that investors now expect higher compensation for holding US government bonds due to a perceived increase in risk. Rating agency Moody’s recently downgraded US debt. Given that the other two major rating agencies had already done so, it is for the first time in over a century that the world’s largest debt market doesn’t have a triple-A rating.

 

The obvious reason for rising nervousness among investors is the expected increase in US government debt. The decline in the dollar is also raising questions. According to estimates, the Bill to extend tax cuts, among other things, which has been passed by the House of Representatives and awaits Senate approval, will alone add about $4 trillion to the federal debt stock over the next decade. That's not all. According to the Congressional Budget Office’s extended baseline projections, the federal debt stock held by the public is expected to increase from approximately 100 per cent of gross domestic product (GDP) in 2025 to over 156 per cent by 2055. Slower economic growth will lead to a significantly faster increase in debt. The US budget deficit has moved to a structurally higher level. It is running a budget deficit worth over 6 per cent of GDP, compared to the past 50-year average of 3.8 per cent. Notably, the US is running a higher deficit despite favourable labour market conditions.  Given the expected surge in debt stock, a significantly higher proportion of expenditure will go towards interest payments (see chart).

 

Net interest payment has increased from about 1.3 per cent of GDP in 2015 to an estimated 3.2 per cent in 2025. This is likely to go up substantially in the coming years and would top 5 per cent of GDP. Such an outlook for the US government’s finances will have atleast three potential outcomes. First, a rising interest burden will alter the composition of government spending and potentially impact growth outcomes. Second, higher demand for funds by the US government to finance its budget deficit will crowd out private investment. It will push up the cost of capital and keep interest rates elevated for much longer than most anticipated, if not permanently. Some commentators have argued that the era of low interest rates is over. Trade-related uncertainties and the impact of higher tariffs on inflation will also limit the scope of policy accommodation by the Federal Reserve.

 

As a result, low investment would hamper productivity and diminish the long-term growth prospects of the US, with direct implications for global growth potential. Third, higher financing requirements of the US government and expected higher interest rates will tighten global financial conditions, making life difficult for countries dependent on external financing. Bond yields have also increased in other developed markets. Although investors are more worried about the US market for valid reasons, debt is rising in other parts of the world as well. According to an International Monetary Fund study covering 175 countries, more than two-thirds now have a higher debt stock than before the pandemic. In advanced economies, the level of debt stock is expected to be at 113.3 per cent of GDP in 2030, about 10 percentage points higher than in 2019.  The debt stock in the US is expected to increase by about 20 percentage points during the same period.

 

Nevertheless, it is hard to argue that the projected US government debt position will force investors to dump Treasuries en masse in the near to medium term, partly because there aren’t too many alternatives. However, sustained higher issuance of government bonds will keep the market on edge. Thus, occasional sharp spikes in yields because of large-scale selling should not be ruled out.

 

A clear takeaway for a country like India, which has growth ambitions and depends on foreign capital to fund its savings-investment gap, is that it needs to prepare for slow global growth and higher financial market volatility, including in the currency market.