Article written by LGT Crestone Head of Public Markets Todd Hoare. Published in The Australian Financial Review November 19 2024.
The US dollar has been the world’s primary reserve currency since the end of World War II. This luxury allows the US government to borrow money at a lower cost, and in greater amounts, than would otherwise be the case.
But with both sides of US politics unwilling to tackle ever-larger fiscal deficits, the risk of “bond vigilantes” demanding greater compensation, through higher interest rates on US treasuries and government bonds, is real.
With Republicans controlling all parts of government, how the fiscal deficit evolves and whether there are offsetting spending constraints will be key to the direction of interest rates.
Although Donald Trump has tasked Elon Musk and Vivek Ramaswamy with slashing US government spending, execution will undoubtedly prove difficult.
The success – or not – of the Department of Government Efficiency (or DOGE), could go a long way to determining whether sovereign and institutional investors would rather lend to cash-rich US corporates than Uncle Sam.
If they cannot conjure fiscal constraint, and remain steadfast on tax cuts, the impact will be felt by all because interest rates may need to stay higher than previously anticipated.
The third rail of a nation’s politics is a metaphor for any issue so controversial that it is effectively off limits, to the extent that any politician or public official who dares to broach the subject will invariably suffer politically.
Domestically, think negative gearing and franking credits. In the US neither party seems willing to address that nation's “third rail” – Medicare and social security.
According to analysis by PIMCO, to balance the US federal budget by 2033, spending would need to be cut by 26 per cent across all spending categories, including Medicare, social security and defence.
However, if social security, Medicare, defence and veterans payments are considered sacrosanct, then 85 per cent of all other spending would need to be cut.
Put another way, outside of raising taxes to cover current and future obligations, it is nigh-on-impossible for the US to balance its budget unless it is willing to apply constraints to Medicare and social security expenditure.
As a result, US federal deficits are widely expected to stay elevated in the absence of higher taxes. Higher spending on Medicare and social security, and ballooning interest payments on debt already issued, are likely to see US deficits hover in the 5.5 per cent to 7.0 per cent of GDP range through the next decade.
Rising deficits clearly have implications for markets. In the UK, the bond market baulked at then prime minister Liz Truss’ large-scale tax cuts and borrowing, sending UK Gilts from approximately 3.15 per cent to 4.5 per cent in a little over a week. In the process, they condemned Truss to the history books as the UK’s shortest-serving prime minister.
The level of fiscal deficits that might prompt a similar reaction in the US are unclear.
However, in the face of falling inflationary pressures, it’s worthwhile noting that the US 10-year government bond yield has increased from approximately 3.6 per cent to 4.4 per cent over the past several months, prompting many observers to wonder if the “bond vigilantes” have turned their eyes to the US.
That doesn’t seem to be the case yet, as the increase in yields has not been corroborated by a simultaneous sell-off in the USD, or in equities, like we witnessed in the UK.
For now, it’s perhaps a reflection of changing nominal growth trajectories, and potentially an acknowledgement that the inflationary backdrop is likely to be more volatile than previously hoped (and hence the need for greater term premia).
US large cap equities mainly have fixed rate, long-duration bonds on their balance sheets.
These bonds also roll over slowly, given maturity profiles. Moreover, the cash on these balance sheets is, in many cases, much larger than the outstanding issuance of debt.
Put another way, many large-cap US companies are net cash. This makes these companies largely insensitive to rising rates – floating rate debt for the S&P 500 as a proportion of total debt is a little over 20 per cent, according to UBS.
Analysis by Société Générale showed the net effective interest rate has barely moved for the top 40 per cent of companies in the US.
Interest coverage ratios (interest expense as a percentage of EBIT) for the top 150 companies remains greater than 10 times.
The epicentre of this strength is the US technology sector. In aggregate, the sector sits on a cash balance that is now approaching $US1 trillion. Combined with strong free cash generation, and consistently low leverage, the sector is well-placed to reward (and protect) both shareholders and creditors.
Despite increasing shareholder returns via dividends (Alphabet and Meta recently announced inaugural dividends), balance sheets offer significant flexibility for all forms of capital allocation – dividends, buybacks, M&A, and reinvestment. Credit metrics and ratings for technology sector debt issuers are expected to continue on a stable-to-improving trajectory.
With $162 billion of cash, Apple’s AA+ balance sheet is among the strongest in the world.
Apple’s bonds due in 2053 (30 years) trade at a spread of just 50 bps over Treasuries. Other large-cap bonds with similar duration trade even tighter, including Alphabet (33 bps) and Microsoft (48 bps).
Microsoft, rated AAA by Standard & Poor’s, stands a single notch above Apple and Google parent, Alphabet (AA+), which in turns is a single notch above Amazon (AA). Meta is rated AA-. By comparison, the US Government holds a AA+ rating.
As one of only two AAA-rated corporate bond issuers (Johnson & Johnson is the other), Microsoft’s creditworthiness is unrivalled.
Although Microsoft has more debt on issuance than a lot of its technology peers, it trades at spreads which are considerably tighter.
Rising government bond yields (not spreads) have seen levels rise from the low 3 per cent to the mid 4 per cent area. For rival Alphabet, with only $12 billion in bonds outstanding, the demand for any potential issuance would likely be very strong, regardless of impending court action.
Alphabet’s cash balance of $100 billion – despite increasing the size and scope of shareholder returns – affords it significant room to issue more debt. Similarly, Alphabet bonds maturing in 2030 trade in the mid-4 per cent range.
Although investment grade credit spreads are at historically tight levels, the recent move in government bonds has now resulted in all-in yields moving into the mid-4 per cent range for many tech issues.
Moreover, it’s possible that spreads are tight (and could stay tight) because tech balance sheets are in pristine condition. Capex discipline, particularly at Amazon and Alphabet is reassuring, and the outlook for the sector should do little to impinge on credit standards.
Phrased differently, it’s quite possible that investors decide that lending to Silicon Valley is a better bet than lending to Uncle Sam.
