The Politics Behind the Rising U.S. Debt

Matt Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy at Morgan Stanley.

Michael Gapen: And I'm Michael Gapen, Chief U.S. Economist.

Matt Hornbach: Today, we'll be discussing the Jackson Hole Economic Symposium and Chairman Warsh's opening remarks.

It's Thursday, August 27th at 10am in New York.

So, Mike, let's get right into it and talk about the upcoming opening remarks by Chairman Warsh at the Jackson Hole Economic Symposium that will be delivered to the public at 10 am tomorrow, Friday. How are you thinking about what to expect from those opening remarks?

Michael Gapen: Well, historically, and by historically, I mean in a post-2008-2009 world, Jackson Hole has been used, not every year, but frequently as a venue to communicate to markets. The longest gap on the Fed's meeting calendar is between the July and September meetings. So, Jackson Hole falls between that and provides a useful opportunity to communicate what might be coming.

That's what's normally been done. Warsh has repeatedly stated he wants the Fed to talk less and communicate less and say less. So, I don't think we will see or hear, in this case, a lot about his views about how the economy is operating today and how monetary policy may be conducted into year-end. So, I don't think we'll hear a lot about, say, the December; the outlook for the economy from September to December, and what it might imply for interest rate policy or balance sheet policy.

So, little in the way of near-term forward guidance.

I do think, however, he did say in the July press conference that the venue would be good to tackle some of these big questions that he has talked about, that he's created these task forces for. So, whether it is the balance sheet or the inflation framework, or communication or AI and productivity or data quality and so forth. This would provide, I think, a reasonable opportunity for him to start talking about that.

I don't think maybe we'll get a lot of conclusions. But I would look for commentary that's more in the question; or in the spirit of those big questions and less about the near-term conduct of policy.

So maybe not what markets want, but this is what markets will get.

Matt Hornbach: Just rewinding a bit, the conference itself is on a somewhat of a niche topic. What exactly is the conference about? And, in terms of the papers that get released at the conference, do you have any sense as to where they might be headed?

Michael Gapen: So, the topic of this conference, the economic symposium, as you noted, is Financial Innovation: [its] Implications for [the] Payments [system] and [monetary] Policy.

So, I would expect there to be a lot of sessions for things like central bank digital currencies or stable coins or Bitcoins. Near money type innovation that has happened in recent years, which leads to things like competition for deposits from the non-financial sector vis-a-vis the financial sector.

So, a competition of near moneyness to money, if you will. Its implications for the interaction between the non-financial system and the financial system, competition for deposits. Does it create risks around financial disintermediation? And therefore, how might the regulatory environment and monetary policy work in that world?

So little more, I'll call it, esoteric and maybe arm's length from the day-to-day conduct of policy. But I would look at the speeches probably in that vein. Deposit competition, financial market stability, and what kind of regulatory framework might you need to ensure we can still conduct policy effectively in that world.

Matt Hornbach: Sounds like an exciting set of papers…

Michael Gapen: Yes. Yes.

Matt Hornbach: … for professors to read through.

Michael Gapen: This is why they don't often leak the schedule too far in advance, right? We all might decide not to listen.

Matt Hornbach: Indeed. Well, it is the end of August, and people are probably still on holiday here and there…

Michael Gapen: I'm doing my best, but you called me in today.

Matt Hornbach: Yeah, the least I could do. So, you did mention that this might be an opportunity for Chairman Warsh to maybe spotlight a bit these task forces and the topics that they're tackling, one of which is the inflation framework.

And that word framework, I think, is important because the investors that we've been speaking with are frustrated that the Fed has not really laid out a framework – for monetary policymaking in this new era of Chairman Warsh, and his leadership at the Fed.

So, I'm curious, if we're not going to get forward guidance on monetary policy and what will happen at the next meeting. And we're also not going to get much forward guidance on the framework that the Fed is using to decide on what to do with short-term interest rates. What are we meant to think about the framework?

Michael Gapen: Yeah, I think ultimately, of course, we're going to need to know this, and this is what economists would refer to as the ‘difference between forward guidance and the "reaction function." So, the framework is really, you've got a set of tools, how do you intend to use them to achieve your objectives?

A conventional Fed would say, "Well, if interest rates are low and inflation's too high, then we should raise rates," right? So high inflation brings high interest rates, low inflation brings low interest rates. All else equal, there's still the employment side of the mandate, of course. And the market had that view, at least initially, right?

As we were in the June-July period and Warsh was talking hawkishly, the curve generally flattened. Expectations for front-end yields moved higher, and inflation-fighting credibility maybe kept the back end stable or brought the back end down. So, you could argue the markets looked at Warsh as maybe bringing a conventional reaction function and a conventional framework.

But in the June and July FOMC meeting and in conversations with the press during the press conferences, Warsh – I don't want to say backtracked. He just didn't validate that and did say that we will achieve price stability. Didn't quite say how he would use the tools to do that. And even suggested maybe interest rates weren't the primary mechanism with which to influence, create, deliver price stability.

So, the curve then steepened out. So, I think the market is wondering what Fed chair we have and what his reaction function is? And if inflation's running hot, is it an interest rate answer or is it a balance sheet answer?

I'd also just add one last thing, Matt, is it makes a difference what the rest of the 18 people on the FOMC think. [Be]cause I think you would agree, and I'll put forward right now, I think they have a largely conventional view. Half of the committee thought it was time to raise rates in June. So, we have a balance between not knowing the chair's framework and having to intuit it. Or hope that we hear more. But then also knowing the other 18 who could band together and have greater voting power act in a largely conventional framework.

I think that's the debate and the dilemma that we're all dealing with.

Matt Hornbach: Yeah, I think investors, have certainly expressed frustration about the lack of guidance in any form or fashion. Perhaps with the exception of the balance sheet; we have a general idea that the balance sheet will be smaller in the future.

And we have a sense from what Chairman Warsh has said in front of the House of Representatives during his semi-annual testimony that any changes would happen gradually over time. But, in terms of the pricing of the July meeting, and what happened at the July meeting, investors were very disappointed that the Fed did not go ahead and raise rates in July.

Now, the market was only assigning about a one in three odds of a rate hike in July. And so, the fact that the Fed did not go ahead and raise interest rates in July was not a surprise in the sense of market pricing. But I do sense that investors were frustrated; that because they didn't get much forward guidance going into the July meeting, that the market might not have priced more probability on a July rate hike because the Fed, in fact, did not signal that they were leaning in that direction.

But I see it as somewhat ironic because it seems to me, and I'd like to get your view on this. It seems to me that Chairman Warsh doesn't want to provide that type of specificity. He'd rather have the markets tell him what to do at an upcoming meeting, as opposed to him telling markets what to do at an upcoming meeting.

How do you think about that?

Michael Gapen: Oh, I think it's… [It] strains credibility to think that by saying nothing, you get the market's interpretation of the economy, data, and events – without the market thinking what the Fed thinks about it. I don't think that there's a world where you get the unvarnished market expectation independent of the Fed.

So, I don't personally agree in the analogy of the market should play the ball and not the referee. The Fed is not a referee in markets. The Fed is a player in markets. Monetary policy acts through financial markets to achieve a set of financial conditions to deliver price stability and maximum employment.

So, the Fed and markets are on the field at the same time. The Fed, in some ways, is the 800-pound gorilla on the field at the same time. So, everybody else on the field has to know what the gorilla is doing in order to do what they're supposed to do.

Yes, there's always some circularity between Fed communication and market reaction to that. But I think that's natural and normal and important in making monetary policy effective – meaning it has to transmit through financial markets.

And so, you could diminish the effectiveness of monetary policy if you don't tell the market what, at least what your framework is and what your reaction function is. And the tools that you intend to use and how you would intend to use them. Then the market could be an inefficient transmitter of monetary policy.

So, I disagree with the notion that by saying less, the Fed learns more. But that's my view. I'm one of many. That's my opinion. The chair obviously has a different view.

Matt Hornbach: Well, I can certainly understand not wanting to be the referee, especially after what we saw at the World Cup. There were a couple of games where the referee…

Michael Gapen: And nobody likes the referee. At least half the people are upset with the referee.

Matt Hornbach: Indeed. Okay. So, Mike, I think we're going to leave it there.

Michael Gapen: Thanks for having me on, Matt.

Matt Hornbach: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today. 

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.

Today, at what point do higher yields and higher debt actually matter?

It's Wednesday, August 26th at 2pm in London.

In its first 240 years, the United States of America accumulated roughly $20 trillion in federal debt. The country has borrowed another [$]20 trillion in just the last 10.

The question for investors is when this debt load will act as a brake on economic activity? Or, worse, create stress that disrupts today's relative calm?

So, let's start with the first question.

For economic activity, the bar seems pretty high. You see, even with all the activity around AI, U.S. corporate debt as a share of the overall economy is broadly unchanged in the last decade and actually lower than where it was before the pandemic.

The balance sheets of the household sector in the U.S. are even stronger. Household debt to GDP is lower than where it was prior to COVID and lower than where it was in the year 2000. And this may even understate the strength – because much of this debt is locked in at historically low mortgage rates; while household assets, the other side of the balance sheet, have soared to record levels.

That may help explain why both consumers and businesses have remained more resilient than expected this year despite the higher interest rates and energy prices.

This divergence of trend between public and private balance sheets is also global. Europe has also seen higher government debt offset by even more private sector de-leveraging, while Japan has seen rising public borrowing and pretty stable private sector leverage.

To some degree, this divergence between the public and private sides of the economy reflects a policy choice. Governments determine how to balance taxation and spending. And many countries, not just the U.S., have reduced taxes over the last decade while allowing public borrowing to increase.

A deterioration of public sector finances relative to private sector finances – it's not especially surprising given that choice.

If strong balance sheets are helping U.S. households and companies be less sensitive to higher rates, where should we look for stress?

Well, for all of this debt, the U.S. bond market is actually still pretty well-behaved. U.S. inflation expectations are roughly unchanged year to date. Expected bond market volatility is historically low.

Indeed, one reason that recent intervention by the U.S. Treasury into the bond market was such a surprise to investors was the lack of these usual stress markers. Instead, the point at which these higher yields might have a larger market impact may be up to another factor: asset allocation.

Today, 30-year Treasury bonds yield about 3 percent more than expected inflation over that period. Long-dated U.S. investment-grade corporate bonds once again yield more than 6 percent. And so, the question of when higher yields begin to matter may be less about when businesses stop borrowing or consumers stop spending. And be more about when investors decide that bonds offer better value than stocks.

So far, Morgan Stanley Research is not seeing clear evidence of that shift. Fund flow data and market correlations do not suggest a significant reallocation away from equities, and strong earnings growth is helping support the equity valuation case.

But these are metrics that we'll be watching. In the meantime, we think that rising U.S. debt and Treasury market intervention may weaken the U.S. dollar, especially against a high-yielding currency with much, much lower debt levels – the Australian dollar.

Thank you as always for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today