The next recession and bear market will be exacerbated by U.S. government debt


There are still a few years left in this bull market for stocks and economic expansion. When this bull market is over, there will be a normal bear market and a recession. But that bear market and recession may be exacerbated by the U.S. government’s debt.

The U.S. government’s debt

The federal debt stands at just below $20 trillion right now. Let’s assume that in a few years, the government spends as much as it does today and the debt doesn’t increase. (The government will likely spend more and the debt will increase in a few years. That only makes matters worse).
The government spends approximately $4 trillion, of which 6% goes towards paying interest on the Federal debt. This amounts to just under $250 billion a year.

Why the debt isn’t a problem right now

The doomsayers aren’t right. The federal debt has not “crushed” the U.S. government yet.
But they aren’t entirely wrong either. The only reason why the government pays so little on its debt is because interest rates are at all time lows.

  1. The 30 year Treasury yield is at 2.7%.
  2. The 10 year Treasury yield is at 2.4%.

Of course, not all of the government’s bonds have been sold at such low interest rates, but much of it has been sold at mid-low single digit yields. This is a historic abnomally.

Why the debt will be a problem in a few years

With the U.S. economy approaching full employment (NAIRU), inflation is coming in late-2018 to 2020. And when it does, interest rates go up. In addition, the Federal Reserve plans to sell trillions of dollars worth of bonds in the next few years. These 2 factors will push Treasury yields up.
As a result, the U.S. government will be forced to borrow money at higher and higher interest rates. If 30 year yields go from a mere 3% to 6%, which historically is a normal target during inflationary periods, the burden of the U.S. debt will double!
This means that the government will have 1 of 3 choices:

  1. Cut spending in other areas.
  2. Increase the debt more and more.
  3. Print money.

Cutting spending during a recession is disastrous. That’s part of what led to the Great Depression.
Raising more debt is difficult during recessions because very few people have money left to buy bonds!
Printing money will merely exacerbate the problem. It pushes inflation and yields even higher, making the government’s debt problem more painful.

The ridiculous solution

An economist raised a solution to this problem. We find his solution to be ridiculous.

The government doesn’t need to finance its debt via long term bonds. It can simply finance its debt via short term bonds. The Federal Reserve – not the market – controls short term interest rates.

This is nonsensical. The government cannot finance its entire debt on short term bonds. Let’s assume that long term rates go up to 8%, and the Federal Reserve artificially keeps short term rates at 2%.

  1. No one is going to buy the government’s short term bonds. No one is going to buy a 2% bond when a similar yield determined by market forces is 8%.
  2. Keeping rates so low while inflation is high will merely drive inflation higher.

12 comments add yours

  1. No arguments with these points here. It doesn’t appear the new tax law will do much to bring down the nations debt either. I think I read that it will actually add to it. It makes me very uncomfortable. Fiscal and monetary stimulus are the primary means to fight a recession whenever it comes and it doesn’t appear their will be much ammo to fight the battle.

    • It will definitely add to the debt. The Republicams passed this bill so they can say “we accomplished a major campaign promise” for the 2018 midterm elections.
      FYI, I support the Republicans more than I support the Democrats. But I’m not going to lie about the real impact of this tax cut. Big boon for the stock market, much smaller impact on the economy. It helps the rich more than the middle class.

  2. Hi Troy, I think you are right. Debt won’t matter until interest rates rise and the next recession spending starts. I often wonder how Japan has managed to stay afloat for the last few years with the debt they have accrued. I will keep investing till the music stops.

    • Japan’s interest rates have hovered around zero for a long time. They’ve faced deflationary fears for the past 2 decades. if Abe’s inflation plan plays out, he risks losing control of inflation. That will be a nightmare scenario for Japanese debt and their economy (japan imports most of its raw materials)

  3. Hi Troy,
    A quick look at http://usdebtclock.org shows each taxpayer owes $904K from all the unfunded liabilities. (Soc Sec, Medicare, Medicaid, Federal debt, and Government benefits due)
    Clearly this is not going to end well. Do you think we can avoid another great depression in the future after the central banks run out of bullets?

    • I don’t know. It depends on how the central bank and federal government wants to get out of this. You can either default (e.g. in 10-20 years), or you can print your way out of it.
      Default is similar to deflation.
      Printing your way out is hyperinflation.
      Obviously neither of these options are appealing. It’s not going to end well, but guessing how badly it will end right now is premature.

  4. Hi Troy.. glad to see that you are back . When do you think the next recession and bear market might begin . Given the scenario above do you expect the next recession to be a severe one like 2008 or milder like 2001

    • 2020 is the target based on current data. This target moves as the years go on. It is not a static target. But it’s pretty much guaranteed that the next recession and bear market will not begin in 2018.
      Depends on how high inflation is at the end of this bull market and economic expansion.
      If inflation is in high single digits, then a scenario like 2001 is more likely. (Nominal GDP contraction will not be severe because of inflation, while real GDP contraction will be severe).
      If not, then a scenario like 2008 is more likely.
      It’s too early to predict how the next recession will play out. You have to take these things one step at a time.

  5. What metrics for the 4th time is in your daytrading “model” that positioned you to short 2683 (the lows of the week )???

    • I don’t think you understand the meaning of proprietary.
      I share the thinking behind my Medium-Long Term Model. I do not share the thinking behind my Day Trading Model.

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