Due to how fragile the middle class is, and due to the pandemic, the government is now running deficits and debts as a percentage of GDP at a level not seen since the 1940s. Image: orhan akkurt/Shutterstock.com
Lyn Alden
Markets began this week with a sell-off. The S&P 500 was down on Monday, with high-flying tech stocks down more on average than the broader index.
It remains to be seen if this is just the start of something bigger, or a mere blip in an upward trend. No trend lines have been broken yet, but overall equity valuations are very high, which presents downside risk.
Treasury yields have been rising as well, meaning that bond prices are falling a bit. So, stocks and bonds went down together to some extent. The 10-year Treasury yield is now well above 1% for the first time since March 2020.
Some of this revolves around the Federal Reserve’s financing of government deficits, or lack thereof. Earlier in 2020, the Fed was buying Treasuries on the secondary market at a faster rate than Treasuries were issued on net by the government, which provided plenty of liquidity and basically monetized the deficit for a period of time. In recent months, the Fed has been buying about $80 billion in Treasuries per month, which is still a lot in absolute terms, but is a lot smaller than the net rate of ongoing issuance to pay for deficits. This leaves the private market to finance a higher percentage of government deficits, and price the bonds accordingly.
The Hundred Year Cycle
If we look at the long-term environment of fiscal and monetary policy, we can see that we’re at an interesting moment in history.
Historically, when interest rates hit zero, the Fed and government turn to other tools to address market and economic conditions. In the 1930s it was a devaluation in gold to recapitalize banks, and in 2008 it was quantitative easing to recapitalize them.
This is a chart of total debt (public and private) as a percentage of the GDP over the past 100 years for the United States, along with short-term interest rates:
Data Source: Federal Reserve, US Census Bureau
We can further break that down, since federal debt and nonfederal debt work somewhat differently. As the issuer of currency, the federal government is bound by different rules than the private sector. Its main limitation is inflation rather than solvency.
Private debt as a percentage of GDP hit a peak level in the 1930s when the banking crisis occurred, and then went down. In the 1940s, during World War II, the federal government ran massive deficits, and capped Treasury yields at 2.5% even as inflation reached into the double digits, which helped inflate away some of the federal debt, to the detriment of cash savers and bondholders, who lost on an inflation-adjusted basis.
Similarly, private debt as a percentage of GDP peaked in 2009 when the banking crisis occurred, and then went down. Specifically, household debt deleveraged substantially, but corporate debt kept increasing. Due to how fragile the middle class is, and due to the pandemic, the government is now running deficits and debts as a percentage of GDP at a level not seen since the 1940s, so the debt chart is starting to look interesting:
Data Source: Federal Reserve, US Census Bureau
From an investor perspective, this creates a lot of uncertainties. On one hand, equities are historically very highly-valued. On the other hand, the broad money supply is increasing at a rapid rate, and interest rates are below the prevailing inflation rate, which gives cash and Treasuries their own risks as well.
Investors can reduce risks and volatility through diversification. In addition to any home equity or investment properties they may have, investors can own domestic stocks, foreign stocks, and bonds within the TSP to provide broad exposure. Investors can further diversify with alternatives such as precious metals, farmland, commodities, or digital assets in other accounts as well.
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The G Fund is Underperforming Inflation
If TSP investors leave money in the G Fund, it is guaranteed not to lose money nominally, but slowly chips away at purchasing power at current rates. On the other hand, if they invest heavily in the equity funds, they have more upside exposure, but also a lot more volatility risk.
Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.
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