Will National Debt Become a Problem for the Stock Markets?

Introduction

The debt levels of the USA and other Western countries are at their highest since World War II. This raises the question of what impact this might have on financial markets.

Current Developments and Their Impact

A minor increase in interest rates by 1.3 basis points (0.013%) in a recent auction of US Treasury bonds was enough to shake international financial markets. The US Treasury auctioned $44 billion worth of seven-year bonds at an indicated yield of 4.637%. Due to weak demand, the actual yield was raised to 4.65%. This small increase pushed the yield on ten-year Treasuries to over 4.6%, while the yield on two-year Treasuries nearly reached 5%.

The Current Debt Situation

The USA currently reports federal debt of $34.7 trillion, equivalent to about 121% of its Gross Domestic Product (GDP). Excluding debt held by government-owned institutions, the public debt stands at roughly 100% of GDP, a level last seen immediately after World War II. The Congressional Budget Office (CBO) forecasts that this debt will exceed 180% by 2050, primarily due to consistently high budget deficits.

The Rising Interest Burden

Interest payments on US debt have surpassed $1 trillion in the current fiscal year, doubling in four years. This interest burden now exceeds the defense budget and has reached late 1990s levels as a percentage of GDP.

Historical Parallels and Political Reactions

Thirty-two years ago, national debt was a major issue in the US presidential election. Today, despite the debt being twice as high, it does not dominate the political agenda. Neither Democrats nor Republicans appear committed to pursuing fiscally conservative policies.

The Role of the Bond Market

The key question remains whether national debt will become a problem for the stock markets. The recent Treasury auction episode suggests that the bond market is increasingly sensitive to debt developments. A larger revolt by the bond market could have significant repercussions for the stock markets.

Possible Scenarios and Their Implications

If the bond market were to revolt against high national debt, the government's response would be crucial. There are four possible ways to reduce national debt:

1. Default: Unlikely, as this would destabilize the entire financial system.
2. Austerity: Politically unattractive, as significant spending cuts and tax increases could trigger an economic depression.
3. Real Economic Growth: Difficult to achieve, as it requires deep structural reforms.
4. Nominal Economic Growth/Financial Repression: The most likely path, as higher inflation is easier to attain and less politically resistant. This would reduce the interest burden relative to economic output.

Conclusion

Whether national debt becomes a problem for the stock markets largely depends on the bond market's reaction. A bond market revolt could cause significant short-term turmoil in the stock markets. However, in the long term, measures such as central bank interest rate control and moderate inflation could stabilize the situation and even have positive effects on real assets like stocks, gold, and cryptocurrencies.

The future remains uncertain, but the development of national debt and the bond market's response will be crucial for the stability of financial markets.

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