The Ultimate Debt Chart: Why central banks hold the key to debt sustainability

Contrary to what economic theory, investors, and economists say, the relationship between the size of debt and yields is negative! This has massive implications for multi-asset portfolios.

Observing central bankers outside their natural habitat is always fascinating, especially when they cannot solely rely on their routine central banking lingo. Federal Reserve Chairman Jay Powell is no exception, as revealed during his annual appearances on CBS 60 Minutes. When questioned about the national debt posing a risk to the economy, Powell remarked, “In the long run, the US is on an unsustainable fiscal path.”

A lack of sustainability is upon us!

However, Powell (likely intentionally) missed the mark by stating that the US’s fiscal policy is unsustainable ‘in the long term.’ To me, long-term sounds like at least ten years, if not more. Yet, the chart below shows that current interest expenses are already the highest in over 30 years. As a percentage of tax revenue, interest expenses are at a 25-year peak.

Eternal optimists might say, ‘Look, we’ve been here before, and it all worked out.’ While a dash of optimism is often warranted, what is being overlooked here is the explosive increase in other government expenditures. Consider discretionary spending like healthcare and defense, ever-increasing stimulus during recessions, and structural tax cuts.

Rewriting the textbooks

The US is not the only country on an unsustainable fiscal path. Quite the contrary. For countries lacking the world’s reserve currency and deep bond markets, debt sustainability issues are bigger and increasingly acute. To avoid precarious situations, governments and central banks will try to kick the debt sustainability can down the road as long as possible. This will translate into structurally low-interest rates, larger central bank balances, and likely higher inflation. After zero rates, negative rates, unprecedented quantitative easing, and yield curve control, it would be naive to think that the 2% inflation target most central banks adhere to won’t be revised.

The biggest debt chart!

The above chart shows the combination of total debt-to-GDP (x-axis) and current 10-year interest rates (y-axis) for the world’s largest economies (excluding Russia and Turkey). The picture is astonishing and defies all basic financial principles. The relationship between debt and interest rates is statistically significantly negative! In other words, the higher the total debt-to-GDP ratio, the lower the interest rate.

The chart goes against all economic theory textbooks and the legions of economists and investors arguing that interest rates must rise due to burgeoning debts and higher inflation. Yet, reality shows the opposite is true and confirms that increasingly extreme central bank policies are necessary to prevent debt sustainability from spiraling out of control.

I would like to emphasize that the focus here is on total debt-to-GDP. Due to various reasons, the distribution across government, corporate, and household debt can vary significantly by country. Caused by, for example, the role and size of the government, the depth of capital markets, and differing interest and tax regulations, such as mortgage interest tax deduction in the Netherlands.

Is the system bankrupt?

So far, I’ve deliberately avoided discussing the still low but increasing chance that the US might fail to meet its obligations. First, before this happens, other (Western) countries will have defaulted already. The US remains the cleanest shirt in the dirty laundry.

The second reason is that even without the system going bankrupt – which won’t happen overnight – current developments are sufficient to warrant a thorough review of your portfolio. I believe most investment portfolios are bond-heavy and lack scarce alternatives like gold. In the next crisis, when interest rates are slashed again and central bank balances spike once more, this portfolio transition will likely accelerate. Hence, it would be prudent to anticipate this now.