There are many constraints on a nascent US economic recovery, notably secular consumer and corporate deleveraging and a dysfunctional and largely insolvent US banking system, but also the unprecedented scale of Federal spending and consequent tax rises. The recent sharp rise in long bond yields to well over 4% reflects not just rising risk appetites, but serious market indigestion at the scale of issuance and rising inflation expectations (the TIPS market now implying 1.7% average 10 year inflation as the deflation panic abates). For the period 1980-2008, federal, state, and local government spending averaged about 35% of GDP. In the current fiscal year, it is projected to surge to 45%,of which all of the surge in spending this year will be covered by borrowing money. The latest estimate of the fast deteriorating federal deficit for this year is $1.8 trillion, or about 12.5% of GDP, hard on the heels of a $1.25 trn deficit in the past year. With the exception of the spike during WWII (a very different demographic era), these numbers take us into uncharted territory, particularly when aggregate US debt is over 400% of GDP. Just yesterday, a report by the trustees of those two key US entitlement programs said the Social Security trust fund will be exhausted by 2037, four years earlier than previously forecast and the Medicare hospital trust fund will become insolvent by 2017, two years earlier than previously estimated. These are huge contingent liabilities on the US government balance sheet, which any buyer of a 30 year Treasury would be wise to weigh carefully.
The latest Treasury data for April on federal government revenues and outlays confirms the collapse in revenues as shown in the chart above. Even assuming those green shoots are being fed Miracle-Gro it's very hard to see a recovery in revenues that is much stronger than the US saw coming out of the 2001 recession. What was then the "jobless recovery" is going to be exacerbated by a recovery facing the headwinds of higher taxes squeezing already falling consumer real incomes and a rising savings rate. That means that tax revenues probably won't turn up meaningfully until 2011 even assuming a sustained rebound. Meantime, we know that spending is on track to reach $4 trillion next year.
The amount of debt that will need to be sold over the next few years is going to test the capital markets to destruction, particularly as key foreign central bank buyers simply won't have the scale of trade surplus to recycle into dollar assets, although higher private sector US savings will help at the margin. In the 1990's the US economy enjoyed a virtuous circle of falling deficits fuelling falling long-term interest rates and booming private sector investment. The outlook now is for precisely the opposite, as trillions in government debt issuance globally crowds out private investment and yields trend upwards to attract a limited pool of available capital. The option of printing more money on top of the $300 bn already committed to the MBS and Treasury market will spook investors further as to the medium-term inflation risks, and push funds into commodities as a real hedge, thus undermining the attempt to boost consumer spending power and creating a vicious economic circle broadly described as stagflation. Debt is going to be increasing much faster than GDP for years to come unlike the post-war situation when GDP growth was sustained in high single digits, and the Fed will be forced to make ongoing purchases of Treasuries, thus monetizing the debt and risking an inflationary breakout if money velocity in the private banking system ultimately accelerates. Rising long-term interest rates are thus likely to be driven by an avalanche of Treasury supply and rising inflation expectations. These are going to be the critical issues to focus on in coming years,and is a reason to expect that economic growth will be sub-par (averaging less than 2%) for many years and coincide with rising trend inflation. Any long-term portfolio should be constructed to reflect that likelihood.
