Site icon Directional Advisors

What I Care About This Week | 2021 Dec 20

Photo by Lisa on Pexels.com

by Franklin J. Parker

The Summary

The Details & Charts of the Week

With government spending, inflation, and the role of the Federal Reserve in the news, I thought it timely to take a closer look at interest rates and government debt, and what we can consider sustainable and unsustainable.

Of course, government debt is at an all-time high (first chart below). Though, government debt is always at an all-time high, so this is not a new situation. It has expanded considerably, of course, but what is of more pressing concern is the second chart, which shows the percentage of the federal budget spend on paying for that debt. We have been able to sustain considerably more debt than “normal” because of the third chart: the effective interest rate on government debt at an all-time low.

The ongoing debate, then, is over the third chart. What is sustainable when effective interest rates are less than 2% becomes less sustainable if those rates move to, say, 4%. Based on current debt figures ($28 trillion), a 4% effective rate of interest would force the US Treasury to spend $1.1 trillion per year on just interest payments. To put that into perspective: in 2019 total federal government expenditure was $4.7 trillion.

In other words, if effective interest rates move back to where they were in the early 2000s (not that long ago!), the US government would be spending about 23% of her annual budget on interest payments—more than double what was paid in the 1980s when interest rates were almost 4x higher.

And this is just assuming a return to a long-term average. If the Fed gets aggressive at fighting inflation and effective rates go to 8%, fully half of the federal budget will be consumed with interest payments. That is about the annual military budget of the United States. That appears unsustainable.

All of this matters because it affects how the Federal Reserve can respond to the threat of inflation. Aggressive interest rate hikes are, in reality, off the table. Some other mechanism will have to be used to pull excess cash out of the economy, though exactly what is an open question.

Investors, as I have said many times before, would do well to remain flexible and closely monitor the tug-of-war between policy, inflation, economic growth, and covid. And the sustainability of government spending will affect all of these.

Total Federal Debt.
Percent of Federal Budget Spent on Debt Service.
Effective Interest Rate on Federal Debt.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

Exit mobile version