The Big Idea
The cost of higher rates
Steven Abrahams | October 13, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Debt markets in the last few years have seen a rapid rise in US debt as a share of GDP and a sharp rise in interest rates. Together these things raise the risk of spiraling debt issuance if the cost of debt service grows faster than nominal GDP. Tax revenues would lag interest expense, and the US would need to issue progressively more debt to cover the shortfall. The possibility of a debt spiral has gone from remote a decade ago to much more than that today.
Debt service obviously depends on both the amount of debt outstanding and the interest rate. The federal government in theory controls the amount, but the market controls the rate. Both have gone up sharply in the last few years. Federal debt held by the public came in at less than 40% of GDP before the Global Financial Crisis (GFC), climbed to nearly 80% before pandemic and now approaches 95% (Exhibit 1A). Longer interest rates have now returned to pre-GFC levels of between 4% and 5% on the 10-year note, but at much higher levels of federal debt (Exhibit 1B).
Exhibit 1A: A rising balance of US federal debt
Exhibit 1B: And a rising cost of US federal debt
Pressure on US debt service would come mainly from repricing of outstanding fixed-rate debt. At the end of September, the Treasury’s monthly statement of the public debt showed $23.1 trillion of fixed-rate bills, notes and bonds with CUSIPs outstanding. That constituted 90% of marketable Treasury debt, the rest in TIPS and floating-rate notes. Since the TIPS and floating rates notes have already repriced to current interest rates, further pressure on debt service would come mainly from repricing the fixed-rate piece. All else equal, that will depend on how high rates go and how long they stay there.
US fixed-rate debt at the end of September carried an average coupon of 2.93%, well below prevailing US Treasury rates but also well below nominal US GDP growth, which since 2000 has averaged 4.4% a year (Exhibit 2). If US debt as a share of GDP stopped growing and the cost of debt never changed, average nominal growth should easily cover debt service.
Exhibit 2: Nominal US GDP growth since 2000 has averaged 4.4%
But if interest rates and outstanding debt stay at current levels and GDP growth comes in at the century average, pressure on US debt service would grow in coming years as debt reprices. To see that, it is straightforward to run an exercise that assumes all outstanding US fixed-rate debt gets reissued in identical amounts at maturity and reprices to current interest rates. That exercise shows debt costs would rise by $109 billion in the next 12 months and by $374 billion in the next 10 years (Exhibit 3).
Exhibit 3: Projected added absolute cost of rolling US debt at current rates
The more relevant result is to translate rising absolute interest expenses into a rising interest rate on outstanding debt. That rate would rise from 2.93% today to 3.40% in the next 12 months and to 4.55% in the next 10 years. The cost of debt over the next decade could rise to a level approaching the century average 4.4% rate of nominal GDP growth. Since debt-to-GDP is at roughly 95%, either debt share would also have to rise or interest rates would have to rise slightly or a combination of the two.
Exhibit 4: Projected rising interest rate from rolling US debt at current rates
Plenty of things could happen to change this simplified outcome. Debt share or interest rates could drop or nominal growth could come in above average or some combination of these possibilities. Of course, debt share and interest rates could also rise and nominal growth could come in below average. There are plenty of moving parts.
The Congressional Budget Office’s most recent projections of federal debt shows the share of GDP rising in the next decade to 118%. In that scenario, assuming rates at today’s levels and debt issued proportional to amounts outstanding today, nominal GDP would have to grow at 5.37% to keep up.
Much of the recent commentary on the recent rise in longer interest rates has focused on rising supply. Behind that may be concern about the risk of US growth getting behind the pace of rising interest expense.
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The view in rates
OIS forward rates now see less than a 10% chance of another hike from the Fed in November and roughly steady rates through April. The same forwards then anticipate 67 bp of cuts from April to December 2024. This picture has changed very little over the last month. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer than expected, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.
Other key market levels:
- Fed RRP balances closed Friday at $1.15 trillion as the facility continues a sharp October decline, down $406 billion this month. Money market funds continue to move cash out of the RRP and into higher-yielding Treasury bills.
- Setting on 3-month term SOFR traded Friday at 540 bp, roughly unchanged in the last two weeks
- Further out the curve, the 2-year note closed Friday at 5.05%, up 1 bp in the last two weeks. Given the likely Fed path, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.61%, up 4 bp in the last two weeks. At that yield, the 10-year note looks compelling. Yields should decline toward 4.0% or lower.
- The Treasury yield curve closed Friday afternoon with 2s10s at -44, steeper by 3 bp in the last two weeks. The 5s30s closed Friday at 11 bp, steeper by 2 bp in the last two weeks.
- Breakeven 10-year inflation traded Friday at 234 bp, unchanged in the last two weeks. The 10-year real rate finished the week at 227 bp, up 1 bp in the last two weeks.
The view in spreads
The Bloomberg investment grade cash corporate bond index OAS closed Friday at 154 bp, wider by 3 bp since Columbus Day. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 186 bp, wider by 9 bp in the last two weeks. Par 30-year MBS TOAS closed Friday at 80 bp, wider by 7 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile since June and trending wider.
The view in credit
Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening, but a lot will depend on how long rates remain high. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B’ and ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.