Trading Signals 05/02 – 09/02
Record U.S. Public Debt: Rising Service Costs
Expenditures of the U.S. budget have reached over half a trillion dollars, accompanied by a drop in revenues. However, the concern extends beyond this aspect: the national debt has exceeded 32.5 trillion dollars, and servicing it is approaching a critical trillion-dollar mark, making it the largest budgetary expense. These circumstances raise doubts about the U.S.’ ability to address its substantial debt and maintain the stability of its financial hub.
What is it About?
The national debt, which is the amount borrowed by the federal government to balance the budget, increases when expenditures exceed revenues and accumulates over time. Typically, it grows due to the expansion of expenses, revenues, and deficits. Inflation usually contributes to higher government expenditures, as well as revenues and deficits.
As a result, the dollar value of the national debt rises during periods of inflation. The debt also tends to increase as the economy grows, although this is not inevitable, as policymakers may choose to balance the government budget.
Higher and Higher
In June, the USA decided to raise its debt ceiling after lengthy discussions in order to continue borrowing money. Presently, the American debt stands at 120 percent of the country’s GDP. Projections from the IMF suggest that it is expected to increase further, reaching 125 percent in 2024, 129 percent in 2025, and 136 percent in 2028. Several factors contribute to this situation, including tax reductions, military expenditures, economic downturns, the pandemic’s impact, and the economic policies implemented under the Biden administration. The national debt has already exceeded 32.5 trillion dollars and continues to grow.
In July, the U.S. Treasury reported a budget deficit of 227.8 billion dollars, which exceeded expectations. Expenditures rose to 646.1 billion dollars, reflecting a 17.6 percent increase compared to the previous year, while revenues amounted to only 418.3 billion dollars. The primary reason for this deficit was a significant drop in tax revenues, declining by 26 percent year-on-year, setting a new record low, even lower than during the peak of COVID-19 lockdowns in June 2020.
The main drivers behind the deficit growth include declining income tax revenues, escalating costs of servicing the debt, and rising social expenditures. Despite a one-time write-off of student loans worth approximately 400 billion dollars in September of the prior year, the main contributors to the deficit are challenging to manage: interest rates on loans, social spending, and taxation. As a result, reducing the budget deficit presents a considerable challenge, and the U.S. Treasury may need to resort to substantial borrowing, as indicated by Evgeny Shatov, a partner at Capital Lab.
The United States finds itself caught in a tight spot: to cover the deficit, they need to increase borrowing, while the expenses for servicing the debt are approaching a critical threshold of 1 trillion dollars. In July alone, the U.S. Treasury spent 122.5 billion dollars on interest payments for the debt, and in the past year, it amounted to a staggering 840 billion dollars. To put it in perspective, the figure was 542 billion dollars the previous year.
The problem lies in the average interest rate for servicing the debt, which reached 2.76% annually in June, and has been at 2.35% on average over the past year. Consequently, the cost of servicing the debt is increasing significantly.
Based on certain calculations, it is projected that interest payments on the U.S. debt could reach a staggering $1.3 trillion annually in just 12 months. This alarming development raises particular concerns as debt payments may surpass even social security spending, becoming the largest expense for the country. In essence, this creates a self-perpetuating cycle: to address budget deficits, more borrowing is needed, leading to higher debt servicing expenses. Consequently, there may be a need for further interest rate hikes by the Federal Reserve, potentially triggering a new global recession. The situation sounds rather pessimistic.
Experts highlight that these factors are greatly amplifying the instability of the global payment system based on the dollar, making the U.S. dollar itself, as the world’s reserve currency, more vulnerable. With an annual burden of over $500 billion in extra interest expenses, both the government and businesses are facing significant challenges during periods of high interest rates. Additionally, the monthly extension of current rates incurs a cost of more than $40 billion.
The stability of the U.S. debt is not a significant concern at the moment. The risks of a federal government default are limited due to the assurance provided by the primary dealer system in collaboration with the Federal Reserve, which pledges to maintain the necessary demand for Treasury securities in case of reduced private sector and non-resident activity.
However, the appeal of American government bonds is diminishing for investors. For example, China has reduced its investments in U.S. Treasury securities to the lowest level in 12.5 years. While five years ago, China held over $1.1 trillion in U.S. government bonds, it now holds less than $850 billion.
Key creditors like China and Japan hold significant amounts of Treasury securities, and they have no interest in witnessing a severe budget crisis. However, the USA must find a delicate balance between maintaining appealing interest rates to attract capital for Treasury securities while also ensuring they can handle the associated costs. Borrowing extensively at high interest rates could lead to a substantial rise in debt servicing expenses.
In such a scenario, a crisis becomes inevitable, and the budget and debt challenges of the world’s financial hub will have ramifications for the entire global economy.