The Independent Market Observer

Knowing When to Worry About the Deficit and the Debt

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 20, 2020 2:06:13 PM

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deficit and debtLast week, I wrote that I was not worried about the deficit and the debt—at least in the short to medium term. We appear to have lots of running room before the debt is an immediate problem, which could be years (or more) away. While acknowledging it as a problem, looking at history and around the world, there are no real reasons it has to be an immediate problem.

That statement begs two questions, though. First, could it become an immediate problem? Second, what warning signs would show that was about to happen? In other words, how would we know when the debt problem is becoming an immediate one and that we should worry?

Rising Interest Rates

To answer these questions, let’s consider what must happen for the deficit and debt to become a problem. When the government issues debt, it is selling those bonds to investors who provide capital. With a limited amount of global capital, investors require a return (i.e., an interest rate) on that capital. Since debt is sold in a market, interest rates are set by investors competing with one another to buy, as shown by their willingness to accept a lower rate than the others.

That market structure—with supply and demand setting the interest rates—is our first indicator of risk. If demand goes down (i.e., there are fewer investors at current rates), then rates have to rise to attract more investors and increase demand. If the supply goes up—if the deficit rises and the government has to increase the amount of debt it is issuing—the same dynamic applies, as more investors need to be attracted to absorb the larger supply, which will require higher rates. Either way, if the deficit is becoming a problem, interest rates will rise. This is the first sign that the deficit and debt are becoming an immediate problem.

Dropping Dollar

But what about the Fed? We talked in the last post about how the Fed can and does buy bonds. Since the Fed is not motivated by profit and has essentially unlimited capital, it can buy as much as it wants, and pay whatever price it wants, in an effort to keep rates low. This, in fact, is exactly what happens in quantitative easing, which we heard so much about in the financial crisis and more recently. If the Fed is all in, we should not expect to see interest rates move. How will we know when to worry in that case?

In one sense, we won’t need to worry, as the Fed will be monetizing the deficit and will be keeping rates low. What we will need to worry about, however, is that by flooding the system with dollars, the dollar itself will lose value—and this is the second warning sign. If the value of the dollar drops significantly, in the context of the Fed monetizing the deficit, this will be another sign the risk has become immediate.

A less valuable dollar would show up in different ways: in the foreign exchange markets, certainly, but also likely in higher inflation, which would push against the Fed-controlled interest rates. If we get the dollar dropping and stagflation, then the deficit risk has become immediate.

These are the major signposts that say the deficit is becoming something that is affecting financial markets. Note that, for the moment, rates remain very low, as does inflation, and the dollar is still reasonably strong against other currencies. All of this indicates that the deficit and the debt are not immediate problems.

Make Decisions Based on the Data

There are reasons for this, of course, not least of which is that every other country is doing similar things, and the U.S., for all its weaknesses and problems, is still relatively in much better shape than its competitors.

It is easy to forget this in the news flow, which is why we need to make decisions based on real data. Worrying wastes time and energy, while understanding and planning help you manage your life and sleep better at night. Keep calm and carry on.

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