Transcription
Take a look at this chart. It shows us the amount of money that the US government spends in paying interest on its debt as a percentage of its total revenue. In 2020, this number stood at only 11%. But today, it has jumped to a record 20%. Meaning for every $100 that the US government's collects in revenue, $20 is now going just to pay the interest on the debt.
The last time we saw anything similar to what we have today was the late 1970s and early 1980s. Now, back then, it was a direct result of the big rise in long-term interest rates that we can see here through the 10-year Treasury yield. The problem today is that even though interest rates are significantly lower than they were back then, the government's interest bill is now the largest it's ever been relative to its revenue.
This setup is about to force the Federal Reserve to do something that they haven't done in almost a 100 red years, and it's about to completely redefine the financial system. Most people think that the Federal Reserve, the US Central Bank, has only two mandates: maximum employment and stable prices. But in 1977, through what's called the Federal Reserve Reform Act, the Fed was actually given three mandates, with the third one being to moderate long-term interest rates.
Today, long-term interest rates are putting real pressure on the functioning of the US government. And this third mandate may be about to be invoked to prevent what's called a debt doom loop. This is more or less what a debt doom loop looks like. Elevated interest rates make government interest payments rise. Those higher interest payments then eat into the government's budget, leaving less money for productive investments like healthcare, infrastructure, and education. This squeezing of the government's budget makes investors less confident in the government's ability to pay back its debt, and so investors naturally demand a higher interest rate to compensate for this risk. This in turn drives interest payments even higher which further squeezes the budget creating a vicious cycle that typically ends in a complete debt collapse.
Now we all know that the federal government and the central bank will do everything to prevent this kind of spiral from happening. And this is precisely where the Federal Reserve's third mandate comes into play. The Fed essentially intervenes by printing money to buy government bonds. Now this artificially pushes down long-term bond yields and breaks the cycle. This kind of policy is called financial repression. The only problem with it is that it tends to create a lot of inflation. For instance, between 1940 and 1950, the US dollar lost 50% of its purchasing power because of this very phenomenon. During that period, food prices nearly doubled, home prices went from around $3,000 to around $7,500, and oil prices tripled from $1 to almost $3 a barrel. All of this was the direct consequence of the Fed stepping in to bail out the government's debt problem.
Now, believe it or not, the US government actually finds itself in a very similar position today to where it was in the 1940s. US debt to GDP has climbed to 120%, the highest level since that very decade. When debt reaches these kinds of levels, even small changes in interest rates can have an outsized impact on the government's budget. This is the very reason for why the US government is already paying record interest payments despite interest rates still being at reasonable levels.
Today, the US government is paying an average interest rate of 3.4% on its debt. According to the Congressional Budget Office, the organization responsible for the US government's official budget projections, this number is set to rise to 3.8% by 2030 and above 4% by 2035. US GDP growth on the other hand currently sits at around 4.7%. But they project that to moderate to around 3.8% by 2030 which we think is relatively reasonable. The problem here is that the moment that these two lines cross, which based on these projections is right here in 2030, is the moment when what the government pays to borrow exceeds the rate at which the economy is growing and generating additional tax revenue for the government. And this is the moment when the debt doom loop scenario that we described earlier becomes a real threat for the US government, unless of course the Federal Reserve steps in.
Now, yes, these projections are for 2030, but this also assumes that long-term interest rates don't move much. On the flip side, if rates were to rise faster than expected, the average interest rate on the debt could jump much more quickly. And so pulling this crossover point forward, for instance, if long-term interest rates were to jump from 4.5% today to 6%, which is the 60-year historical average of interest rates, well, the average interest rate on the government debt would jump to 4% by 2027. In other words, the crossover with GDP growth could happen as soon as next year if long-term interest rates continue to rise in the US. And if that plays out, the Fed would need to step in and invoke its third mandate far sooner than most people realize and begin a policy of financial repression, which as we discussed earlier would essentially rewrite the financial system.
So the big question now is whether we should expect long-term interest rates to actually rise and trigger this. Well, if we look at long-term Treasury yields and we put the rate of inflation in the US on top, we can see that the long-term breakout in rates was a direct result of this spike in inflation. That is simply because investors demand a higher interest rate to at least protect the real value of what they are owed. Unless, of course, the Fed steps in and doesn't allow this to happen. For example, if you lend the US government $100 for one year and inflation is running at 5%, then by the time you get that money back, it can only buy $95 worth of goods. So, naturally, you'd want the government to pay over 5% in interest to at least break even on your money and make some return for the risk of lending.
This is something that we clearly saw back in the 1970s where inflation reached as high as 15% and drove long-term interest rates to over 15% as well. More recently, inflation has stayed above the Fed's 2% target for now 60 consecutive months. And this has put a lot of upwards pressure on interest rates as investors have demanded compensation. In 2026 alone, inflation has spiked from 2.4% to 4.2%, more than double the Fed's target. This poses a serious risk of pushing long-term interest rates significantly higher from here and causing a debt doom loop scenario.
There is one important caveat to this, however. Most of the recent rise in inflation has been driven by one factor and that is oil. Oil is an input that is needed for pretty much everything in the economy from transportation to food to manufacturing. So as oil prices were rising, it pushed up the cost of almost everything else along with it. As you can see, in recent weeks, however, oil prices have been coming back down quite sharply, suggesting that the recent pick up in inflation could prove to be quite temporary. This move actually significantly reduces the risk of interest rates breaking out in the near term. So while the risk of financial repression is very real, we do not think that we are currently in an environment where the Fed needs to step in in the near term. But over the next decade, we do expect this to take place. US government spending is too high and interest payments on the debt are growing at an unsustainable pace. This will eventually lead the government to be fully trapped by its own debts. And once long-term interest rates rise, the Fed will have little choice but to actually step in with financial repression.
Now, you might be thinking that this sounds like a terrible environment for any kind of investment, one where the stock market would surely see a vicious decline. But history actually tells a very different story. If we rewind to the 1940s, once the Fed deployed a financial repression and the dollar began rapidly losing its purchasing power, the stock market actually rose. Cash, on the other hand, as we already know, lost 50% of its value over that same decade. So, while most people might think that a market crash is imminent if a government debt crisis occurs, the reality is that an environment with high inflation and low interest rates that causes severe currency debasement is a massive risk for the US dollar, not the US stock market. After all, the stock market is priced in US dollars. So, as the dollar loses purchasing power, the nominal price of the stock market actually tends to go up. This is something that very few people actually understand about today's environment.
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