The Days Ahead:

  • Fed meeting.

This Week:

  • Part 1 of a look at the budget deficit and debt.
  • Total debt to GDP is at post-World War II levels.
  • The CBO projects deficits above 5% of GDP for the next 10 years.
  • Neither political party has realistic plans to reduce debt levels.
  • The relationship of interest rates to debt is complicated.
  • Are current rates too high, too low, or just right?
  • A long look at history provides some answers.
  • We had a “flash crash” but no harm done other than to the dignity of the NYSE.

Budget Deficits Aren’t Going Away

Over the next few months, we’ll hear a lot about budget deficits. What we won’t hear about are tax increases or budget cuts. But deficits aren’t going to solve themselves.

The 920-page report from the Heritage Foundation’s Mandate for Leadership in 2025, the closest thing we have to a Republican manifesto, doesn’t refer to the budget deficit directly. It does recommend 1) a reduction in crop insurance subsidies, saving $2 billion a year on a $6,135 billion of expenditures, 2) that the Treasury should sell 50-year treasury bonds to lock in low rates, and 3) that all agencies should be good stewards of taxpayer money. But that’s about all.

The Democratic party has tried to increase taxes, usually on the rich and corporations and with re-tread polices like carried interest. But neither side is going all out on a “reduce the budget deficit” platform yet.

We feel that deficits matter and they’re going to be a concern for voters. In the next few weeks, we’ll put out a longer piece addressing deficits, their history, current predictions and their effect on the economy, markets, and investors.

For now, here’s a primer.

Figure1 Deficit Since 1942
Source: FactSet, 05/30/2024

The above chart shows the amount of public debt outstanding as a percent of GDP. We use the $27,480 billion of public debt rather than the $34,616 of total debt. The difference between the two is held by intragovernmental agencies and does not need public financing. You’ll hear both numbers kicked around as well as a debt-to-GDP ratio of 95% for public debt and 121% for total debt. But in each case, the lower number is the correct way to look at the debt.

At current levels, the 95% of GDP level is equal to the post-World War II level. That was a time when the U.S. had just finished financing a global war and implemented European reconstruction through the Marshall Plan, which alone cost 5% of GDP.

Since the 2017 tax cuts, government revenues rose 40%, expenditures by 63% and GDP by 46%. Personal taxes are up around 47% and corporate taxes up 20%.

Simply, the government spends more money than it takes in. Whether the government spends too much or doesn’t tax enough is beyond the scope of this author! The deficit, however, is a hard fact.

The next chart shows the budget deficit as a percent of GDP by year. Debt, in the first chart, is how much we owe. The deficit is how much we spend over what we take in. You often hear the terms interchangeably, but they’re quite different.

We show the deficit in blue bars both historically and out to 2034 as estimated by the Congressional Budget Office (CBO). They’ve been doing this since 1974 and they make it clear that estimates assume no change in laws, spending and taxes. Sometimes their estimates are accurate. In 1982, the estimated budget deficit for 1986 was 4.3% for 1986 and it turned out to be 4.8%. Sometimes they are less accurate. In 1996, the CBO estimated a 2000 deficit of 1.5% which ended as a surplus of 2.3%.  

We think of the CBO not as a forecasting tool but as an extrapolation of what will happen assuming no changes to any fiscal policy. In other words, it’s a base line.

Figure2 Deficits and Treasuries Chart
Source: FactSet, 06/04/2024

In the next 10 years, the CBO sees GDP growing by 48% to $41,646 billion, revenues up 60%, expenditures up 90%, and interest payments up 87%. Discretionary spending increases by 19% but mandatory spending (Social Security, Medicare, veterans benefits etc.) increases 64%.

On the revenue side it also assumes a drop in corporate taxes from $569 billion to $551 billion. Those are not inflation-adjusted numbers. They drop from 2.0% of GDP to 1.3% mainly because of a 2022 ruling that allows companies to deduct 100% of expenses of new investments and they expect to pay more in foreign income and so claim tax credits. It’s complicated but, as we noted, the CBO goes with what’s on the statute books.

The green line shows the 10-year Treasury rate. In theory, the higher the deficit, the higher the interest rate at which the government borrows. But the relationship is complicated. Sometimes rates are climbing when the deficit is flat, as in the 1950s, and sometimes rate falls when the deficit increases as in 1982, 2001-2003 and 2008 to 2012. We’ll dig into this further and other deficit forces in coming weeks.

Meantime, expect more headlines and “what about the deficit?” questions.

Are Interest Rates Too High, Too Low or About Right?

The 10-year Treasury sits at around 4.4% which is about 1% above the CPI index or 1.7% above the Fed’s preferred PCE inflation index. We don’t know if this is the correct rate. For the last 70 years, the 10-year Treasury traded about 2% above inflation. This suggests the rate is too high, or that the market expects inflation to fall.

Figure3 Bonds and Inflation 50 Years Chart
Source: FactSet, 06/03/2024

In the top chart, inflation is in green, and the 10-year Treasury in blue and the lower chart shows the difference between the two. When the line is above zero, bonds yield more than inflation.

In the 1960s, inflation was below 2% and the 10-year Treasury was around 4%-5%, so the gap between the two was more like 3%, well above the 70-year average of 2%.

In the 1970s inflation took off to 14% and bond rates rose. The average rate for both inflation and 10-year rate was 7% from 1972 to 1979 but ranged all over the place, from a 10-year Treasury yielding 3.5% above inflation to 4.8% below.

For most of the 1980s, the 10-year Treasury traded 6% to 8% above inflation. That narrowed to 2% for the 1990s and 2000s but then the financial crisis of 2007 turned inflation to deflation and bonds yielded about 0.5% to 1.0% more than inflation.

Currently bonds are about the right price relative to inflation for the 2010 to 2020 period, expensive compared to the 1980s (meaning bond yields should rise), somewhat expensive compared to the 1960s but cheap compared to the 1970s. Or in simpler form:

Figure4 10 Year Table
Source: FactSet, Cerity Partners

It’s clear that a simple look back at what’s normal doesn’t get us far.

Let’s look further back. This shows annual inflation (bars) and the real 10-year Treasury rate (green line), since 1914.

Figure5 Long Term Inflation Chart
Source: FactSet, 06/03/2024

We also include information on who the Fed chair was at the time and  events that may affect either inflation or rates. But the Fed Chair’s party affiliation or momentous events like starting and stopping the gold standard all bear little relation to the interest rate and inflation relationship.

Sometimes the rate difference, or real rate, is very high, especially in deflationary periods. In the early 1920s and 1930s the 10-year Treasury had a real yield of over 22%. Good if you’re a saver, but prices fell 40% in 1921 and GDP fell 40% from 1930 to 1934.

Figure6 800 Years of Rate Chart
Source: Rogoff, Rossi, Schmelzing

The real rate was very low during World War II when the Fed pegged rates at 0.2% and initiated price controls. The difference from 1941 to 1948 was around -13% which meant your savings lost 60% of their purchasing power in six years. Once the Fed removed the peg and price controls in 1948, inflation and rates took off.

The 120-year-term average inflation of 3.3% and real 10-year rate of 1.4% would suggest rates today should be higher. But the ranges are too wide to be helpful.

Let’s go even further back. This is the real rate of interest and the 30-year moving average from 1317 to 2023.

The earliest traded government bond that we know about was issued by Venice in the 14th century to finance trade with Alexandria. The real rate of return averaged around 5% for the next 200 years, but, again with huge swings depending on wars, plagues, revolutions and empire building.1

If there’s a pattern it’s 50 years of declining rates, followed by 10 to 20 years of increasing rates, and a heck of a lot of volatility in between. There was a long 400-year down trend from 1580 that makes the 1980s and 1990s look like a blip. The recent 30-year trend is down but that includes the GFC zero rate period. The rate doesn’t stay below or near the zero line for long.

So, where does that leave us? Long-term history suggests real rates should be higher. But how much depends on whether you look at 50-year, 120 year or 700-year averages – and whether you leave out the non-war, high inflation, monetary debasement periods. But it doesn’t tell us if  we get to a higher rate by rates rising or inflation falling. We know from history that the current phase is calm. We have lower inflation and positive real rates. And we can see that markets are not as volatile as they have been in the past. That’s one good thing.

Did This Really Happen?

Monday brought excitement when the “A” class, voting shares of Warren Buffett’s Berkshire Hathaway (BRK). did this:

Figure7 BRK Chart

They started the day at $620,000 a share, having closed last Friday at $626,000. Then at around 11:30 AM EST they spiked to $701,000 for two minutes and dropped back to $634,000 before closing at $633,000.

But that’s not the whole story.

The move on Monday was, ahem, down to a technical issue.

The shares opened at $620,0002. At around 11:00, 13 shares traded at $940,000. From 11:20 to 11:40 some 20 shares traded at $700,000. At 11.50 more shares traded at $185 (sic), thankfully only for about one minute. A few lucky traders bought shares but the trades were all cancelled under the NYSE’s “clearly extraneous transaction” rule that says any transaction more than 3% above or below the last transaction is “aberrant”. The NYSE implemented a short selling ban for three hours.

BRK wasn’t alone. Shares in Barrick Gold fell from $17.00 to $0.25 for 35 minutes and NuScale Power fell from $7.60 to $0.13 for over an hour.

What happened? It was all an error in the newly updated SIP, or securities information processor, which feeds stock prices to data providers like FactSet and Bloomberg. Nobody made or lost money over the error and it all settled within a few hours. Still, it showed “flash crashes” are still a thing despite numerous gates and precautions.

The Bottom Line

Weaker economic numbers, specifically in manufacturing and job openings sent the 10-year Treasury yield lower. It’s now at the bottom of the 4.3% to 4.7% range it’s been in since early March. Every move builds on the “how strong is the economy and is inflation trending down?” question. The answer is that the economy is slower but not worryingly so – jobs are holding up and inflation is slowly retreating.

The Bank of Canada became the first G7 central bank to cut rates, although the Swedish Riksbank and Swiss National Bank (neither is in the G7) beat them to it back in April. The Fed will take longer to cut but the cycle has definitely turned.

We saw three major elections in Mexico, South Africa and India. The first went as expected, a win, but with a larger majority. The Mexican peso, up 25% in the last two years, fell 8%. The African National Conference lost big and the rand also fell. In India, Prime Minister Modi won but with a smaller majority and stocks fell around 9%. India, up 22% in the last year, has been one of the best-performing stock markets in the last few years and is more expensive than the S&P 500. We’d expect markets in Mexico and India to settle down.

The S&P 500 hit an all-time high on Wednesday with Nvidia eclipsing Apple to become the world’s second largest stock by value.

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Art of the Week: Andre Derain (1880-1954)

  1. 1 The spike in the 15th century was the great “bullion famine” when Europe ran a large trade deficit with the Middle East and was unable to pay in silver. In 1557, France, Spain and the Netherlands all defaulted leading to a spike in real rates and 40 years of increasing rates. ↩︎

  2. 2 Berkshire Hathaway (BRK) is the S&P 500’s sixth largest company, not some meme stock that can move on small volume. BRK is the world’s highest priced stock. That’s on purpose. Warren Buffet owns 38% of the company but 64% of the voting shares. The A shares are worth around $353 billion and the B, nonvoting shares around $534 billion for a total company value of $890 billion. The B shares are around $400 per share and intended to provide easy access for retail investors. The A shares are at a deliberately high price to show how much the shares have risen since Buffett took control of the company in 1966 at a price of $19.00. The stock has never split, so it’s easy to see the appreciation of the stock over the decades. The high price also discourages quick trades, although that’s less of an issue in these days of factional trading. ↩︎

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