Episode Details

Our Global Head of Fixed Income Research Andrew Sheets discusses when and how higher yields and mounting U.S. debt could become more than abstract concerns.

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----- Transcript -----

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.