Credit: How Policy Rates Affect Deficits
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Chief Investment Office29 Sep 2023
  • With US national debt surging past USD33t, interest expenses comprise a larger portion of budget
  • High Fed Funds rates imply high costs of maintaining large reserve balances at banks
  • Accelerating QT may be more effective than raising rates in tightening conditions
  • Remain up in quality (A/BBB) and short-duration (3-5 years)
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Broken record of US debt breaking records. It was not long after the US had raised the debt ceiling that treasury issuances have gushed forth as though the house no longer had a roof. The US national debt was reported to have surged past a record USD33t this month (>120% of GDP), pushing us far beyond the Rubicon of what is conventionally acceptable as “sustainable levels of debt”. While government largesse is an obvious scapegoat for the ills of indebtedness, it would be perhaps surprising to learn that the Fed hiking cycle – left unchecked – would eventually make Federal interest expenses a predominant cause of deficit spending, making the Fed Chair more consequential to fiscal responsibility than Congress or the President himself.

Interest expenses to the moon. The data itself is staggering. Since the Fed had embarked on the first 25 bps hike in 2022, gross interest payments on US debt have increased by c.50% to c.USD970b within a span of one year, according to data from the Federal Reserve Bank of St. Louis (Figure 1). Interest is in all likelihood going to surge past the ominous USD1t mark, given that a sizeable 34% of interest-bearing treasuries are maturing within 12 months; the sharp rise in rates over the past year all but ensure that costs of refinancing have nowhere to go but up.

Interest payments becoming a budget constraint. Granted, the Treasury does account for some interest receipts (in the form of social security, retirement benefits, student loans, etc.) to mitigate interest payments on a net basis, but such offsets are no panacea to the overwhelming force of higher rates. Based on interest projections under various yield scenarios, a prevailing 4-5% interest rate environment would eventually see net interest payments still rise towards the USD1t level, almost with an air of inevitability.

The US Congressional Budget Office (CBO) is also acutely aware of this risk, projecting that net interest payments would surge to c.USD835b by 2025 (the deadline for the debt ceiling suspension). Ceteris paribus, this would make net interest payments a larger component of the budget than other mandatory categories such as National Defense and Medicare. Given that a non-negligible portion of such interest payments go to foreign (some perhaps not US-friendly) holders, congress may eventually be called into question regarding why certain foreign parties are benefitting at the cost of higher domestic US liability.

Figure 1: US gross interest payments have risen exponentially in light of the hiking cycle

Source: Federal Reserve Bank of St. Louis, DBS

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