Investors should pay attention to how the Fed and the Treasury deal with the huge national debt. Higher interest rates would not be good for the stock markets and would increase the cost of servicing the debt. Lower Fed interest rates would help the stock markets and lower the cost of servicing the debt. If the Fed does not raise interest rates or lowers them even by a small margin, investors can assume that the Fed has taken a dovish stance, and that would be good for equities. It would also be good for the Treasury as it struggles to manage the debt.
The US National Debt Clock tracks the amount of US federal debt and a slew of other debts. The federal debt is now over 22.2 trillion dollars and rising. The best source for figures on the cost of servicing the national debt is a website of the Treasury. In connection with the federal debt, one should also take into consideration the CBO (Congressional Budget Office). This government agency foresees a budget deficit of one trillion dollars in 2020 and the same in the following years. By 2030 the debt will probably be more than 30 trillion.
“Deficits: CBO projects a 2019 deficit of about $900 billion, or 4.2 percent of gross domestic product (GDP). The projected shortfall (adjusted to exclude the effects of shifts in the timing of certain payments) rises to 4.7 percent of GDP in 2029.”
The Fed Will Work with the Treasury
One can find a wealth of statistics on the sites noted above, but their interpretation requires some thought. Investors should be aware of these figures since they determine how the Fed and Treasury act and react in the real world. The fact that the Treasury is going to have to find financing for the budget deficits means that liquidity is going to be sucked up by the federal government. It is a foregone conclusion that the Fed will step in to monetize the federal debt if the market does not provide sufficient funds to cover the deficits as well as to continue financing existing debt when the time comes to roll it over. The Fed is more likely to be increasing its balance rather than reducing it, which it currently plans to continue doing until September of this year. So it is likely that there is going to be a tightening up of liquidity due to the needs of the government with the Fed standing by to fill in if need be.
Higher Fed Interest Rates Would Increase the Cost of Servicing the Federal Debt
The Fed's plan to “normalize” interest rates has resulted in the basic interest rate moving up to about 2.44% from practically nothing in 2015. This is going to have an effect on the amount of interest that the US government is going to have to pay out in interest on the debt. The fact that the Treasury could service the rising debt of the Obama years was due to the ZIRP and NIRP of the Fed that was adopted in order to save the economy during the GFC of 2008. It was possible to service the debt at a very low cost. This is going to change as new Treasury debt is issued at higher interest rates for bills, notes and bonds. In simple language, rolling over the debt is going to mean higher costs for servicing it. The CBO sees net interest payments rising from 1.8 percent of GDP in 2019 and by 2029 reaching 3 percent of GDP. It is well known that CBO forecasts are usually rather inaccurate, but the general tendency of a rise in debt servicing costs for the federal government seems to be a reasonable hypothesis. The CBO has not taken into account a possible recession.
Inflation Could Be an Important Factor
What this is going to mean for investors is not at all clear because the factor of inflation should be considered. One cannot trust the figures for inflation that the government fabricates. The Federal Bureau of Labor Statistics has its own arcane methods of producing statistics and usually “adjusts” them for seasonality and other factors. It is obvious that the BLS could tend to keep inflation figures (Consumer Price Index) lower in order to avoid large increases in workers' salaries. It all depends on how the consumers' “basket” is made up and the weighting assigned to each category or product. The great inflation in the price of equities is not something that receives much attention in calculating inflation for consumers. It is fair to assume that the BLS will continue to produce low inflation figures even if the real rate of inflation is higher.
The Need for Liquidity
Even so, that will not have a great effect on the yields of fixed income securities because the Treasury's need for liquidity will be a major factor influencing the market. Corporations will have to offer higher rates of interest on new bonds in order to attract capital. Companies that are already highly leveraged are going to face higher financing costs. That will be the case both for new debt as well as for rolling over existing debt. It is highly likely that the default rate for corporations is going to rise as the effect of Fed interest rate increases works its way through the economy.
Get Out of Shale Oil
The outlook for the shale oil industry is full of ominous signs as over 300 billion dollars of debt is going to have to be refinanced in the next five years. Even with an oil price over $60 a barrel, depletion rates and capital expenditure for new wells are going to push many producers into bankruptcy as the cost of refinancing debt rises. In addition to that, there will be tightening liquidity. Investors should beware of the shale oil producers trying to entice them into putting their hard-earned money into the shale oil industry either by way of stocks or bonds. There is thus a connection between the rising cost of servicing the federal debt and the fracking industry. The government's need to finance its debt is going to mean higher costs for corporations to finance debt and tightening liquidity, and that is going to wreak havoc on the shale oil industry. It would be wise for investors to get out of the shale industry before the crunch comes.
Share Buyback Programs Will Be More Expensive
The need for liquidity on the part of the Treasury to roll over and service the federal debt is also going to influence corporations when they plan their share buyback programs. The rising cost of financing debt is going to mean that corporations will have to weigh more carefully the advisability of making debts to finance share buybacks when the market at present is reaching new highs. Executives will have to reckon that the high prices for equities now means share buyback programs will be very expensive in addition to the higher costs for financing debt. Financial engineering may not be successful in avoiding a collision between a market downturn and higher interest rates. Of course, Fed interest rates are historically extremely low. See the chart below. One should reckon that the economy must be really weak and overleveraged if a minimal increase in rates can cause the market to do what it did in the first half of December 2018. The economy has become addicted to low interest rates and will suffer the consequences with zombie companies surviving and pension funds becoming desperate due to unfunded liabilities.
Stock Market Highs Mean Increased Risk
Investors should realize that the increase in federal debt and the higher costs of servicing that debt are going to have consequences for the entire economy and not only the stock market. The fact that the stock market has recently hit new highs should not blind investors to the increased risk now that equities have become more expensive. The Treasury is going to have to finance the federal debt and the budget deficits. That will mean tighter liquidity and a possible recession. If the Fed monetizes a large portion of the budget deficits, the Fed balance will increase. Keeping interest rates low to accommodate the Treasury will favor deflation. Japanifiction of the US economy will become a real possibility. Implementing QE could cause further inflation of equities. Investors will have to watch out and carefully observe how the Treasury and the Fed go about handling the budget deficit and rolling over 22.2 trillion dollars of debt. President Trump will not want to pay 2.5% on federal debt. It remains to be seen how independent the Fed will be. The Fed might even raise interest rates if there is higher inflation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.