| | |  | | THE DEBT CRISIS SCENARIO | 
The following is an excerpt from the October 4, 2023 Yardeni Research Morning Briefing.
Debt Crisis I: A Plausible Scenario? “We’re going to have a debt crisis in this country,” Ray Dalio, the founder of hedge fund Bridgewater Associates, warned in an interview with CNBC’s Sara Eisen that aired last Thursday. The two were speaking at a fireside chat at the Managed Funds Association. “How fast it transpires, I think, is going to be a function of that supply-demand issue, so I’m watching that very closely.”
Melissa and I referenced Dalio’s debt crisis scenario yesterday. It’s a simple plot that makes sense. We’ve been covering the story but haven’t concluded that it must end as badly as Dalio expects. Consider the following:
(1) Fiscal policy is out of control, as evidenced by the rapidly widening federal government budget deficit. Over the past 12 months through August, the deficit totaled $2.0 trillion, up from a recent low of $1.0 trillion through July 2022 ( Fig. 1). It’s simple arithmetic: The trend in outlays is steeper than the trend in revenues ( Fig. 2).
In the past, the federal budget deficit was counter-cyclical. As a percent of nominal GDP, it widened when the economy fell into recessions and narrowed during expansions ( Fig. 3). As a percent of nominal GDP, outlays rose during recessions and fell during expansions ( Fig. 4). Receipts tended to do the opposite of outlays.
So it is disturbing to see that outlays are rising while receipts are falling during the current economic expansion.
(2) It is widely assumed that the recent widening of the federal deficit is mainly attributable to the spending programs enacted by the Biden administration during 2022. In fact, the recent widening is mainly attributable to inflation, which has boosted federal government outlays on Social Security and net interest ( Fig. 5).
Net interest totaled $634 billion over the past 12 months through August ( Fig. 6). It has doubled since April 2021. It is the fastest growing of the federal government outlays categories ( Fig. 7). We calculate that the federal government is currently paying about 2.50% on its outstanding debt held by the public ( Fig. 8). The 2-year Treasury note is currently above 5.00%.
The biggest contributor to the bulging deficit in recent months has been a decline in individual income tax revenues during the current fiscal year after they were boosted last year when investors sold lots of their stocks that had capital gains during the 2022 bear market. They paid lots of capital gains taxes.
(3) Outlays will get boosted even more in coming years by all the spending Congress approved last year. In addition, the net interest expense of the federal government will continue to soar, as it has been doing ever since the Fed started raising interest rates aggressively in 2022.
(4) The Treasury supply issue came to the fore during the past summer, when the Treasury securities outstanding held by the public jumped by a whopping $1.4 trillion from June through August ( Fig. 9). Fitch Ratings downgraded the federal debt from AAA to AA+ on August 1 on concerns about the mounting federal debt and the lack of political will in Washington to do anything to rein in the deficit. That announcement really marked the start of the Treasury bond market’s concern about too much supply relative to demand. The 10-year bond yield was 4.05% on August 1. Now it is almost 4.80%.
(5) So the bond market is adjusting yields upward to clear the market, i.e., to boost demand to meet the increased supply. The risk is that the market yield will crowd out the credit demands of the private sector. That would amount to a credit crunch, which would cause a recession.
In the debt crisis scenario, a recession attributable to excessive fiscal deficits would require the federal government to reduce spending and increase taxes, which would exacerbate the credit crunch and the recession. In a worst-case scenario, it could unleash a deflationary debt default spiral. In this scenario, the Fed might be forced to lower interest rates and to terminate its quantitative tightening.
Debt Crisis II: It Doesn’t Have To End Badly. Okay, now let’s come up for some air from these lower depths. So far, the Treasury bond yield has essentially normalized to the yield levels of 4.00% to 5.00% that prevailed from 2003 to 2007, before the “New Abnormal” ( Fig. 10). That was the period from the Great Financial Crisis through the Great Virus Crisis, when the major central banks worried about deflation and obsessed about raising the inflation rate up to their 2.0% targets. During that period, interest rates were abnormally low and quantitative ease proliferated.
So far, the economy has proven remarkably resilient in the face of the three-year jump in the bond yield from a record low of 0.52% on August 4, 2020 to almost 4.80% currently. This raises the possibility that the economy can live with the bond yield back to its old normal level.
Then again, the velocity of the rate backup has been head-spinning, as it took only three years to fully reverse the decline in the bond yield during the 12 years of the New Abnormal. Depressing lagged effects on the economy are likely still to emerge. However, they might continue to play out as a rolling recession rather than an economy-wide recession. The rolling recession is currently rolling into the commercial real estate market.
What would it take to stop the Treasury bond yield from climbing well above 5.00% other than a deflationary debt debacle? Possibly the “immaculate disinflation” we expect. That is, we think inflation can continue to fall without an economy-wide recession. We also expect to see a slowdown from Q3’s consumer-led boomlet, with real GDP rising to between 4.0% and 5.0%. We think that Q4 real GDP growth will be back down to 2.0%. In this scenario, demand for Treasuries should absorb the supply with the yield south of 5.00%.
Be warned: If we see the yield soaring well above5.00%, we (along with everyone else) will have to conclude that Dalio’s debt crisis might have started.
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