abstract
The US fiscal expansion has led to a deterioration in the fiscal outlook, and CBO estimates are significantly underestimated. According to CBO's forecast, it is expected to exceed the level of World War II in fiscal year 2029 and reach 181% of GDP in fiscal year 2053. During this period, the deficit rate will also continue to rise, expected to reach 7.3% by 2033 and 10% by 2053. However, there are obvious unreasonable assumptions in the CBO prediction, including:
1. Significantly underestimate borrowing costs. According to the CBO's economic forecast for February this year, the current March US bond yield should be 4.6%, and the Federal Reserve has entered a rate cut channel, with a future long-term average of 2.3%. According to the TIP10 breakeven inflation rate, the future inflation level is estimated to be 2.34%. Conservatively estimating a natural interest rate of 1%, the expected March US Treasury yield should not be lower than 3.24%, which means that the deficit rate is underestimated by at least 1%.
2. Significantly underestimate defense spending. Significantly underestimating defense spending. According to CBO predictions, by 2033, US defense spending will decline to 2.8% of GDP, reaching the lowest level since data was available. Against the background of counter globalization, the Russia-Ukraine conflict, the Middle East war, and the competition from China, the United States cannot fail to increase its defense spending. Even at the average level of the past 20 years, defense spending is still 4.4%. In this case, conservative estimates suggest that defense spending is underestimated by at least 1.6%.
3. Significantly overestimate income according to current laws. According to policy practice, the Bruce Institution has re estimated long-term fiscal revenue, and the result is expected to be 1% lower than the CBO's current legal forecast, which means the deficit rate is underestimated by 1%. With a decrease in comprehensive income and an extension of tax cuts, the deficit rate may have been underestimated by 1.5%.
Qualitatively speaking, such an underestimate means that the US deficit rate may be 3-4 points lower than expected. This means that the future deficit rate of the United States will remain in a state of financial crisis for a long time.
From the perspective of three factors, the central rise in long-term interest rates in the United States may be a highly probable event. The 10-year US Treasury bond interest rate consists of three components: real interest rate, inflation, and term premium. The natural interest rate, as a theoretical economic equilibrium, cannot be directly observed and can only be estimated using a model, which has a significant impact on the method of model estimation. If natural interest rates do not rise, the US economy should have already entered a recession as expected by the market at the beginning of the year. Referring to the estimation results of the Laubach Williams model, a natural interest rate of 1.5% may be a more conservative estimate. For a long time to come, a 10% deficit level is likely to become the norm for the US economy. Against the backdrop of anti globalization, the benchmark scenario should raise expectations for future inflation levels, with 2.5% being a relatively conservative estimate. Based on the uncertainty of inflation and the changes in the supply and demand relationship of US bonds, it seems that the term premium of US bonds should be higher than the low inflation period under globalization since 2000, while the average level of term premium over the past 20 years is 0.74%. If we are more conservative, we can assume that the term premium in the future is 0.5%. Therefore, under relatively conservative assumptions, the long-term interest rate center in the United States should not be lower than 4.5%.
Risk reminder: Financial risks in the United States exceed expectations, and inflation exceeds expectations.
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1. The severity of financial problems is underestimated
1.1 The downgrade of the overall rating and the resignation of the Speaker are all financial issues
The downgrade of the US rating by Fitch and the resignation of the Speaker of the US House of Representatives all reflect US fiscal issues. In early August of this year, after the bipartisan debt ceiling agreement was reached in the United States, Fitch Ratings downgraded the US government's credit rating, one of the reasons being the increasingly heavy debt burden. In early October, Republican right-wing elements voted to step down through a recall motion, making McCarthy the only speaker in US history to be dismissed, due to dissatisfaction with the cooperation between US House Speaker McCarthy and the Democratic Party in passing a temporary spending bill, which violated previous campaign promises to reduce government spending. Behind these events are significant expansions in US fiscal spending, with a growth rate of nearly 20% in the past 12 months, second only to the financial crisis and pandemic period; The proportion of fiscal expenditure to GDP is close to 25%, even higher than during the financial crisis.
1.2 Fiscal sustainability, deficit will reach 7.3%
With an increase in expenditure, the growth rate of government debt will exceed the GDP growth rate for a long time. According to the prediction of the U.S. Budget Office (CBO), the U.S. debt will increase in an unsustainable way, that is, the growth rate of debt will continue to exceed the growth rate of GDP in the next three decades, which is expected to exceed the level of World War II in fiscal year 2029 and reach 181% of GDP in fiscal year 2053. During this period, the deficit rate will also continue to rise, expected to reach 7.3% by 2033 and 10% by 2053. The 10% deficit rate will be second only to World War II and the pandemic, and the 7.3% deficit rate will be second only to World War II, the financial crisis period, and the pandemic. The main reason for the increase in the deficit is that expenditure will significantly increase, from 24% of GDP in 2022 to 29% in 2053. The increase is mainly due to the impact of rising healthcare, social security, and interest expenses, especially the 2.8 percentage point increase in the proportion of healthcare expenditure to GDP.
Three Reasons for Excessive Underestimation of 1.37.3% Deficit
Significantly underestimating borrowing costs. According to the CBO's economic forecast for February this year, the current March US bond yield should be 4.6%, and the Federal Reserve has entered a rate cut channel, with a future long-term average of 2.3%. According to the economic forecast released by the Federal Reserve in September, the upper limit of the target range for the long-term federal funds rate has increased from 2.8% to 3.3%, indicating that the Federal Reserve has raised its expectations for the natural interest rate R *. Taking the average of the target range and the inflation target as the estimated natural interest rate R *, it is 0.9%. Considering significant factors such as the high US fiscal deficit and anti globalization, the expected level of long-term inflation of 2% is significantly underestimated. According to the TIP10 breakeven inflation rate, the future inflation level is estimated to be 2.34%. So the more conservative expected March US Treasury yield should not be lower than 3.24%. That means the CBO forecast is nearly 1% lower. Considering that the proportion of US debt in GDP will soon exceed 100%, this means that CBO underestimated the future deficit ratio by at least 1%.
Significantly underestimating defense spending. According to CBO predictions, by 2033, US defense spending will decline to 2.8% of GDP, reaching the lowest level since data was available. Against the background of counter globalization, the Russia-Ukraine conflict, the Middle East war, and the competition from China, the United States cannot fail to increase its defense spending. Even at the average level of the past 20 years, defense spending is still 4.4%. In this case, conservative estimates suggest that defense spending is underestimated by at least 1.6%.
Significantly overestimate income according to current laws. In the absence of significant tax cuts, the US fiscal revenue in the first eight months decreased by $410 billion compared to last year, equivalent to 1.5% of GDP. Even with last year's revenue as the benchmark, linear extrapolation shows that the annual fiscal revenue will decrease by 3% compared to expectations. In the long run, there is also an overestimation of CBO predictions. According to CBO's prediction, the default tax reduction introduced by Trump in 2017 will expire in 2025. But in fact, Congress is likely to delay this tax reduction bill, as the Biden administration has promised not to increase taxes on individuals with incomes below $400000. According to policy practice, the Bruce Institution has re estimated long-term fiscal revenue, and the result is expected to be 1% lower than the CBO's current legal forecast, which means the deficit rate is underestimated by 1%. With a decrease in comprehensive income and an extension of tax cuts, the deficit rate may have been underestimated by 1.5%.
The CBO benchmark forecast significantly underestimated borrowing costs, significantly underestimated defense expenditures, and significantly overestimated income according to current laws. Based on the above qualitative analysis, the deficit rate should be underestimated by 4.1%, and if it is more conservative, it may be underestimated by 3%. Therefore, in the long run, the United States may maintain a 10% deficit rate for a longer period of time, which is the level of the financial crisis.
2. US fiscal imbalance and central rise in long-term interest rates
The long-term interest rate, commonly known as the 10-year US Treasury rate, consists of three components: real interest rate, inflation, and term premium. Through qualitative analysis of these three parts, it seems that the central rise in long-term interest rates is a high probability event.
2.1 Natural interest rate rise raises real interest rate
The natural interest rate R * may have increased. The natural interest rate R *, as a theoretical economic equilibrium under which the actual interest rate cannot be directly observed, can only be estimated using a model, and is greatly influenced by the method of model estimation. According to the estimates of the New York Federal Reserve, the natural interest rate in the United States was 2.2% in 2023 and decreased to 1.56% in 2027, significantly higher than the previous 1% level. For determining whether the natural interest rate R * has increased, it may be more convincing from the perspective of evidence to the contrary. If R * did not rise, under such aggressive interest rate hikes by the Federal Reserve, the US economy should have already entered a recession as expected by the market at the beginning of the year. From the market trading results, the implied real interest rate of US bonds has also reached 2.24%, which is the highest level in the past 20 years. We use the commonly used Laubach Williams model estimation results as a reference. The estimation of natural interest rates is greatly affected by the recession, and has significantly decreased after the financial crisis, but has been on an upward trend over the past decade. Referring to the estimation results of the Laubach Williams model in 2019, a natural interest rate of 1.5% may be a relatively conservative estimate.
2.2 Underestimation of inflation expectations
The long-term inflation level may be significantly higher than 2%. According to the previous analysis of the US fiscal deficit, a 10% deficit level is likely to become the norm for the US economy for a long time to come. 3% is the international warning line, and 10% is the crisis level. The government's fiscal expenditure is often concentrated on the server side, which is likely to lead to higher service inflation. And commodity inflation is affected by anti globalization, making it difficult for the United States to continue enjoying China's cheap goods. A typical example is the severe inflation problem caused by the stimulus of the epidemic, but the fiscal stimulus during the financial crisis did not have a significant impact. Therefore, the benchmark scenario should raise expectations for future inflation levels, with 2.5% being a relatively conservative estimate.
2.3 Term premium carries upward risk
Conceptually speaking, term premium refers to compensation for the risk of future nominal interest rate fluctuations, hence it is also known as risk premium. The term premium is mainly influenced by two factors (Bernarde, 2015): 1. investors' perception of bond risk; 2. Supply and demand relationship.
Conceptually, the connotation of term premium is consistent with the bond risk measured by the MOVE index. The higher the MOVE index, the higher the uncertainty of future expected interest rates. So the MOVE index measures the price that investors are willing to pay to avoid the impact of interest rate fluctuations, and therefore has a strong correlation with the trend of term premium.
For investors, the uncertainty of inflation is the main risk of long-term bonds, but the market may not have fully priced it. Both the high inflation periods of the 1970s, 1980s, and recent pandemic periods have been accompanied by an increase in term premium, and CPI has a certain degree of leadership in terms of term premium trends. After the recent rebound in CPI, the term premium has also shown a significant rebound. From TIPS' 10-year breakeven inflation rate, the current market expectation for long-term inflation is only 2.34%, which seems to have not fully taken into account the impact of the United States' large long-term fiscal deficit and anti globalization factors. In addition, for investors, the uncertainty of short-term economic or monetary policy can also affect the risk of bonds.
Under the context of anti globalization, the demand for US bonds in emerging markets is decreasing, and the imbalance between supply and demand will lead to an upward term premium. The market generally believes that an important reason for the significant increase in term premium in the near future is the increase in US bond supply, but the shortage of marginal buyers in high interest rates. Over the past two decades, China and Japan have been the largest buyers of US bonds, especially China. But China has been continuously reducing its holdings of US bonds since 2014, while Japan's willingness to buy is not high and is basically flat. Under the Russia-Ukraine conflict, the G7 countries, in violation of the principle of sovereign immunity, jointly frozen Russia's foreign exchange reserves in disguised form, which is also causing many developing countries to shift their foreign exchange reserves from US debt to gold. In addition, in the context of high inflation, it will be difficult for the Federal Reserve to directly and significantly purchase US bonds. In the context of high deficits, the increase in US bond supply is relatively certain, so from a medium to long term perspective, the rise in US bond supply and the decrease in demand will lead to an increase in term premium.
Based on the uncertainty of inflation and the changes in the supply and demand relationship of US bonds, it seems that the term premium of US bonds should be higher than the low inflation period under globalization since 2000, while the average level of term premium over the past 20 years is 0.74%. If we are more conservative, we can assume that the term premium in the future is 0.5%.
2.4 Long term interest rate center of 4.5%
Based on expectations for real interest rates, inflation, and risk premiums, the central interest rate for 10-year US Treasury bonds may be higher than 4.5%. Under relatively conservative estimates, our expectations for future real interest rates, inflation, and risk premiums are 1.5%, 2.5%, and 0.5%, respectively, corresponding to a long-term interest rate center of 4.5% for 10-year US Treasury bonds. It should be pointed out that this estimate is relatively conservative and there is a significant possibility of underestimation. In fact, the 30-year US bond yield has already exceeded 5%. Under relatively aggressive estimates, if the actual interest rate is 2%, the inflation rate is 3%, and the risk premium is 0.7%, then the long-term interest rate of the 10 US Treasury bonds may also reach or even exceed the level of 5.7%.
Risk reminder: Financial risks in the United States exceed expectations, and inflation exceeds expectations.
Article Source
For the complete official report, please refer to the Northeast Securities Macro Research Report "Northeast Macroeconomics: US Economic Resilience, Fiscal Imbalance, and Long Term Interest Rate Central Rise". Chief Macro Analyst: Zhang Chen
This article is sourced from the selected research reports of securities firms