Matthew Hornbach: Why U.S. Public Debt Matters

As U.S. Public Debt continues to break records, should investors be concerned by the amount debt has risen? Or are there other, more influential factors at play?

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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Morgan Stanley's Global Head of Macro Strategy. Along with my colleagues, bringing you a variety of perspectives, today I'll be talking about how macro investors may want to view rising U.S. public debt. It's Tuesday, October 18th, at 10 a.m. in New York. 

U.S. public debt made breaking news headlines this month by rising above $31 trillion for the first time. In a decade, it's projected to hit $45 trillion, according to the Congressional Budget Office or CBO. By the time new hires today are ready to retire, U.S. debt to GDP could be at 185%. 

The CBO argues that high and rising debt could increase the likelihood of a fiscal crisis, because investors might lose confidence in the U.S. government's ability to service and repay its debt. They also believe that it could lead to higher inflation expectations, erode confidence in the U.S. dollar as a reserve currency, and constrain policymakers from using deficits in a countercyclical way. 

The government debt load in Japan has stood as a notable counterpoint to concerns of this nature for decades. With gross debt a whopping 263% of GDP, and no fiscal crisis that has occurred or appears to be on the horizon, Japan's situation should mitigate some of the CBO's concerns. 

Still, the amount of debt matters, especially to those invested in it. As both the level of debt and interest rates rise further, net interest income for U.S. households may contribute more to total income over time. 

Nevertheless, the level of government debt vis a vis the size of the economy and its contribution to societal income, are not the most pressing issues. The problem with debt has always been predicting the price at which it gets bought and the value it provides investors. The current size of the debt at $31 trillion is just a distraction. This staggering number fundamentally diverts attention from what matters most here. 

So what does matter the most here? First, the speed at which the debt accumulates. Second, the risk characteristics of the debt that investors will buy. Third, the price at which investors will buy it and the value it provides at that price. And fourth, the major drivers of the yields in the marketplace for it. 

The amount of debt, the Federal Reserve's retreat from buying it, and foreign investors' waning appetite have left some analysts and investors wondering who will buy at all. The relevant question for macro investors, however, is not who will buy the securities, but at what price. The marginal buyer or seller moves prices, not the largest. Consider that at least 3.5% of outstanding U.S. Treasuries change hands every single day. That's an open invitation for many investors, including those who use leverage, to move prices. 

So what determines the level of Treasury yields over time? In the end, the most important factor, at least over the past 30 years, has been the Fed's interest rate policy and forward guidance around it. 

So, bottom line, macro investors should pay more attention to the Fed and the economic data that the Fed care most about than the overall amount of government debt investors will need to purchase or which investors will do the buying. 

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