A frequent question I hear from well-meaning investors is this: “Hey, I read that China owns U.S. government bonds worth $1 trillion and if they decided to dump them into the market it could spike interest rates overnight and crash the U.S. economy. Are you worried about that?”
While this is certainly a logical question for an intelligent person to ask, the answer is much more nuanced and complicated than you would think, for two very important reasons. First, we can look at the interest rate at which the U.S. government must use to pay its debts to see the world’s view of our creditworthiness, and therefore the view of risk of the U.S. debt picture unraveling. And second, a government budget deficit is a very different thing than a consumer budget deficit.
First, we must look at the credit rating of the United States. Even for an equity guy like myself, I believe in a maxim that markets trade on: Equity markets trade on hope, while bond markets trade on truth. There may be a myriad of opinions on the true value of Netflix stock, some may say $100 a share while others may say $1,000. Each opinion is based on a unique set of facts and viewpoints, and only in the future will some investors be proved correct and others widely off the mark. There is no “wrong” opinion on a stock at the current time, and investors buying stock at the current price are doing so while predicting or hoping that the valuation and stock price will be higher in the future, thereby justifying their investment.
However, the bond markets are different and more sober, as lending money is based purely on currently available financial information about the borrower, and past actions that display creditworthiness. Although my 21-year old son may run faster, be better looking, and have a bright future ahead of him, if he applied for a car loan by himself, he may get a 12 percent rate for a loan, while I may get approved for a 6 percent rate if I applied for the loan myself. All that matters to those that lend money to others is the credit rating of the borrower, which is based on his perceived desire and ability to pay the money back to the lender.
Greece government bonds traded at 15% in 2011 because the market judged that the chance for default on the bonds was very high, and the market interest rate moved higher to reflect that fact. U.S. bonds trade at very low rates today because the world’s credit investors judge us to be very likely to repay our debts. The world’s opinion on the creditworthiness of the U.S. is reflected in the interest rates on its bonds. And the world is telling us that the U.S. is a very safe place to invest and store money. There is no hope in all these judgements of borrowers, just truth.
To answer the China question above, the simple reply has two parts: First, why would China do that? And second, what would they then do with the money? China does own a lot of U.S. government debt, but they are very smart people. By buying our bonds (i.e. loaning money to the U.S.) they are showing a high level of confidence in our ability to repay the debt at a future date. Money flows where it is treated best, and China must feel that the combination of high creditworthiness and a higher interest rate than they could get elsewhere relative to the risk, is a good deal for them.
Also, if China did sell all their U.S. bonds, what would they then do with the money? German bonds yielding negative interest rates? Russian Ruble futures? Spanish government debt? Bitcoin? The lack of comparable alternatives to U.S. bonds is a powerful catalyst to stay put. For the U.S., the fact that many investors and countries around the world want to loan us money at a very reasonable rate is not a weakness, it is a strength, which displays the confidence that people have in us to repay our debts. Yes, our national debt is at an all-time high, but it is still very low as a percent of total GDP. And our large national debt level has not affected the world’s view of our strong credit rating, as displayed in our interest rates.
Second, regarding the all-time high U.S. national debt, we must make a distinction between a government budget deficit and a personal or consumer budget deficit. On a personal level, if I consistently spend far more than I earn in income, then I must finance that spending by borrowing from others, such as a mortgage, on a credit card or taking on personal loans. This behavior is in fact ill-advised, as I will need to pay back the principal on all these debts sooner or later, which will cause me and my family financial trouble when the bills come due.
However, a government budget deficit is a different creature. A government has taxing power of its citizens and businesses. A government has a currency that it can print more of to pay its debts. And most importantly, the Gross Domestic Product (GDP) of a country can grow faster than the level of debt that it takes on, thereby reducing the size of the debt relative to the overall economy and its growth and earnings power. The U.S. national debt in 2019 totals more than $22 trillion and that is indeed a large number. However, we must remember that it is not the actual total of debt that truly matters for a nation’s fortunes, it is the level of debt when compared to the overall size of the economy and its economic growth trajectory.
U.S. national debt as a percent of our total economic output (GDP) is not at a high level, and the economy may grow at a much higher pace than inflation over the coming decades. So, while the U.S. does generate a budget deficit every year, our overall economy is growing at a faster rate than that growth of debt, and with interest rates at low rates, the country can certainly afford to service that debt. Interest rates are a function of the outlook for growth and inflation for an economy. Economic growth may prove to be slower in the future than the present, but inflation looks to remain firmly under control of the Federal Reserve. These conditions should lead to a continuing level of low real interest rates.
Words of the Wise: Modest rates of inflation, low real interest rates and a healthy growth in the U.S. economy makes both budget deficits and a growing national debt tolerable. And given the highly favorable interest rates that investors bless our bonds with, it shows that global investors see the U.S. as a safe haven in which to park and invest their funds, in the past and in the future.
