The Big Idea
The cost of higher rates
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. This material does not constitute research.
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
Source: Federal Reserve, Santander US Capital Markets
Exhibit 1B: And a rising cost of US federal debt
Source: Bloomberg, Santander US Capital Markets
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%
Source: Bloomberg, Santander US Capital Markets
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
Note: exercise assumes all fixed-rate US debt with CUSIPs in the Treasury Monthly Statement of the Public Debt as of 30 Sep 2023 matures and is reissued in identical amounts and with original term at interest rates on 10 Oct 2023.
Source: US Treasury, Bloomberg, Santander US Capital Markets.
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
Note: exercise assumes all fixed-rate US debt with CUSIPs in the Treasury Monthly Statement of the Public Debt as of 30 Sep 2023 matures and is reissued in identical amounts and with original term at interest rates on 10 Oct 2023.
Source: US Treasury, Bloomberg, Santander US Capital Markets.
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.
* * *
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.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.