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When Debt Pushes Back

Wells Fargo Investment Institute - March 2018

George Rusnak, Co-Head of Global Fixed Income Strategy for Wells Fargo Investment Institute Investment, explains how the magnitude, trend, and timing of the growing U.S. debt burden could impact the domestic bond market.

Transcript: Monthly Investment Outlook: When Debt Pushes Back

The rising U.S. federal debt burden now ranks the U.S. among the most leveraged developed-market countries. 

According to the Congressional Budget Office, recent changes to tax policy and the budget will increase the U.S. Treasury debt burden by a combined $1.8 trillion over 10 years. And our nation’s debt burden has risen significantly (as a percent of gross domestic product or GDP) over the past 10 years. This quickly escalating debt/GDP ratio puts the U.S. sovereign credit rating at risk for a future downgrade by some rating agencies, if left unchecked. 

Many have attributed the recent increase in Treasury yields to concern over the growing U.S. Treasury debt burden and the higher debt-to-GDP ratio that is expected to result from recent U.S. fiscal policies. We view this market reaction as a healthy one, given the magnitude, trend and timing of the growing U.S. debt burden. 

How could these changes impact the domestic bond market? 

The U.S. currently finances its debt on a relatively short-term basis, and it likely will need to refinance close to $4 trillion in debt over the course of this year alone. The refinancing of

substantial amounts of Treasury debt in the near term could translate to higher interest-rate volatility in 2018 and 2019. 

Additionally, we believe that overall demand for U.S. Treasury debt may decline, which is an important changing dynamic for the bond market. An increased supply of Treasury debt, combined with weakening demand for Treasury securities, is likely to lead to higher U.S. interest rates.

And as fiscal stimulus begins to run through the U.S. economy, it should fuel additional economic growth, which probably will increase inflation—likely leading to moderately higher interest rates as well. 

Another unique aspect of the rise in U.S. fiscal stimulus this year is that we are adding federal debt late in the domestic business cycle. We believe this warrants concern because any sign of weakening growth may need to be addressed through more aggressive monetary policy in the future, at least in the short term. 

We believe that investors should prepare for a moderately increasing, and more volatile, interest-rate path than we experienced in 2017. We would: 

Seek a more defensive bond positioning in terms of yield curve, credit and structure 

Prepare for more interest-rate volatility and the possibility of a market overcorrection creating investment opportunity 

Diversify globally within fixed income, especially in emerging-market debt. 

Rising Treasury debt late in a business cycle does represent a market risk. By diversifying broadly across fixed income sectors and geographies, as well as across asset classes, investors may be able to mitigate the risks of rising interest rates. Investors should be prepared for the possibility of a bond-market overcorrection that could offer investment opportunity.