Trinh

Happy Memorial Day to Americans! And good morning to Asia!

Let's talk about something very topical. Debt. Yes, it has risen. How much debt do we have really? Who owns it? Why is cost of debt an issue?

Can the US solve its debt crisis? 

This chart is my fav chart. I show stock of debt & then flow of debt (change since 2019 in orange bubble). Debt matters in terms of who owns it, which sector, etc. 

Who is the biggest debt of them all? Well, Japan. It is also the biggest creditor to the world (lending money). Japanese debt is unique in that because of weak private sector, the government has been just expanding like crazy because the households and corporates just sit on savings.

Okay, why is this important? Well, those savings traditionally invested in their own debt (used to be very low yielding on the longer end) and also OTHERS' debt, USA + other emerging markets, also Europeans etc.

The Japanese sovereign yield curve is interesting not just for Japanese lifers, banks & JGB strategists but also for everyone else.

What has happened? Well, per usual they will run fiscal deficit. Nothing new. But the BOJ also owns like 48% of this debt and wants to reduce, but very hard because lifers etc don't want to buy so much more of this supply.

So what happens? The yield curve steepens. What is a yield curve? Well, you can borrow short-term (overnight) or for a long time (30 to 40 year in Japan) at a set rate. Japan has been running very close to zero rate for a long time.

So debt is not an issue if your servicing costs were close to zero. 

But the longer, esp the 40-yr is now 3.5%. Yep!
The shorter end, which is policy rate is 0.5%.

This curve is STEEP!

For a country running at 3.6%YoY inflation rate and the policy rate is 0.5%, the REAL POLICY RATE IS NEGATIVE. But if you take into account the longer end yield, which for the 15 year, it's 2.5% ish level, then it's not that bad. And at the 40-year, real policy rate is FLAT. 

So there is more juice to squeeze if you want to take the duration risk. And that has this implication:
a) Japanese investors now have choices. They actually have positive yield (even real yield negative, much less than before);
b) BOJ prolly will hike, question is when;
c) Demand for JGBs etc higher
d) LESS BUYING OF FOREIGN DEBT. What exactly?

The US debt. Government debt. The US government used to also have zero interest rates, they raised it & also needed reduce all that massive buying.

This process is called tightening. Policy rates, after being cut, is still high at 4.5% for the upper bound. VERY HIGH. Why? Inflation is only 2.3%YoY.

Compare that to Japan 0.5% policy rate and inflation hot at 3.6% (meaning nominal GDP growth in Japan prolly rocks). 

Okay, so everyone is talk about US debt because we now have LESS FOREIGN BUYING, specifically Japanese but not only (China obviously for geopolitical reasons). And the Fed is still doing QT at 5bn (very little but still). Anyway, 4.5% policy rate.

So the 10 year is, wait for it, 4.51%!!!

Is the yield curve STEEP? NO, IT'S FLAT COMPARED TO JAPAN.

What about the 30-year? 5.03%

Yes, that yield curve is FLAT EVEN IF IT STEEPENED. We are talking about 53bps from overnight to 30 YEAR!!!

Why do I emphasize this point even if everyone is screaming US DEBT IMPLOSION???

Well, because, yes, at higher rates and a higher stock of debt, you are paying more interest expenses. Btw, mostly to your own people because 70% of that debt is owned by Americans and they pay taxes on that income. 

Anyway, so as the US issue MORE DEBT (FISCAL DEFICIT = BORROWING MORE) and want to extend its duration, WE HAVE SERVICING COSTS rising on average because we have a lot of debt issued at low rates (although also bills issued short-term need to refinance).

But considering that the longer end, even with all that selling off etc, it not that STEEP. DON'T CRY A RIVER.

Why? Because the US has policy levers.

The FED can CUT. Why? It is not suffering from being at ZERO BOUND.

The BOJ is. The BOJ has rates at 0.5% when CPI is at 3.6%YoY.

This is not a good position to be in. It will need to hike or CAN'T CUT. No sir, your inflation is too high. People pissed off about rice price. Cutting or hiking won't solve it but JPY being weaker will cause import prices to go up.

Okay, what about le Fed? Despite what markets are saying, the Fed has PLENTY OF TOOLs.

The EASIEST is to cut. Inflation is at 2.3%Yoy. This week there will be some PCE numbers market will watch.

What's the consensus for April? 2.2%YoY.

Yep, we have the short-end at 4.5%! The Fed can cut!!! Yes it can. It has SPACE to respond to the business cycle & debt load.

https://www.minneapolisfed.org/-/media/assets/papers/wp/wp810.pdf

You may say, well, what about the dollar being weak and TRUMP MR TARIFF MAN???

Certainly tariffs = inflationary. But what inflation? First, GOODS IMPORTED. Those things are not exactly the MOST CORE TO US inflation.

But tariffs do more dampening via consumption and investment sentiment so you can actually have people dropping more than the impact of tariffs.

This is what the Fed paper argues, just published in May.

So what should the Fed do? CUT! Respond to output drop.

https://www.minneapolisfed.org/-/media/assets/papers/wp/wp810.pdf

People say, well, I don't agree. It doesn't matter if you do or not.

The reality is this: THE FED HAS POLICY SPACE. Rates are at 4.5% & it can cut because inflation is not at 5%.

Can it be 5%? Unlikely. It's at 2.3%YoY. 

So it will cut. When? Prolly September. How DEEP can it cut? 

Well, it depends but it has PLENTY of room. It can cut to 3% for example easily.

Remember that the BOJ can't even hike 25bps after all that inflation. SO IT HAS LIMITED SPACE. 

The Fed has done something amazing - which is to TIGHTEN SO MUCH WITHOUT CAUSING A CRASH.

Remember that everyone has been calling for a US HARD LANDING EVERY YEAR SINCE 2022.

Three years later, we are in 2025. The Fed still has rates at 4.5%. 

Anyway, I want to talk a bit about the EU too. It actually has FISCALLY CONSOLIDATED a lot but there is obvs huge bifurcation (Germany savers vs others etc). 

The point regarding the EU is that they are CUTTING!!! The deposit rate is 2.25% and they will cut more in June to 2% and MORE!

So people comment on the fact that Europeans are borrowing cheaper than the US, well they should, their policy rate is LOWER.

And that being said, their CURVES ARE STEEPENING. Especially Bund, which is the government debt for Germany.

Why is this important???

Well, it means that it's attractive to hold some decent yield now for traditionally super low yielding.

So WE HAVE GLOBAL COMPETITION FOR YIELD. And the POSITIVE YIELDERS ARE NOW DEVELOPED MARKETS.

Yes, true story. 

So these foreign BUYERS of USTs face the following questions:
a) Current real yield good but HUGE UNCERTAINTY regarding future inflation + fiscal deficit + etc so HIGHER TERM PREMIUM, btw, which is NORMAL
b) USD going lower? Higher? Valuation effect here if you are JPY buyer unhedged; might as well stay home if u think JPY will appreciate vs USD.
c) What about this crazy Miran paper idea of LONG BOND etc?? Man, that scares me. I stay away from duration. 

Haha. Anyway, but UST at 5% level is ATTRACTIVE.

Long story short:

If you are a saver, you got a lot of choices now to invest. Yields are getting juicy as you WANT TO BE PAID FOR RISKS.

Risks are being priced more accurately in my opinion. 

Central banks can SUPRRESS that with rate cuts. ECB will cut soon. 

The Fed will cut. There is no doubt. Of anyone, and this is my NON-CONCENSUS opinion, the US has a lot options. More than you think.

The easiest option is rate cuts. Plenty can happen. Can take it easily to 3% level.