The $22 Trillion Question

The tone was apocalyptic: “The U.S. federal budget is on an unsustainable path . . . . The scale of the nation’s projected budgetary imbalances is now so large that the risk of severe adverse consequences must be taken very seriously.” The growth in the American federal debt and deficit would soon produce a “fundamental shift in market expectations and a related loss of confidence both at home and abroad,” and the resulting “fiscal and financial disarray” would “depress economic activity much more than the conventional analysis would suggest.”
These warnings came not from Chicken Little. The white paper was co-authored by Robert Rubin, President Clinton’s Treasury secretary, and Peter Orszag, President Obama’s director of the Office of Management and Budget. If these two were worried, perhaps there was something to worry about.
Yet these words were published in January 2004. Since then, the total public debt outstanding has tripled and the debt-to-gross-domestic-product ratio has more than doubled. Current spending policies have steepened this trajectory: The Treasury Department anticipates $1 trillion deficits starting in 2022 and the Congressional Budget Office forecasts the federal debt relative to GDP to hit its highest level since the end of the Second World War by 2029, and to reach unprecedented territory soon thereafter. Including state and local debts in addition to unfunded pension obligations (all of which the federal government implicitly backstops) increases the total tally of debt outstanding by about 25 percent.
Yet in the shadow of this mounting debt pile, Treasury yields — the compensation investors require for holding these securities — sit at historic lows. President Clinton’s chief strategist James Carville’s wish to be reincarnated as the all-powerful bond market seems as quaint today as Rubin and Orszag’s warnings from 15 years ago. The bond vigilantes have been driven from the land, their homes burnt and fields salted. The bond investor of today instead channels Alfred E. Neuman: “What, me worry?”
The U.S. Treasury market is the largest and most liquid financial market in existence, and it underpins all investments and asset classes. If the Treasury market sneezes, global financial markets, and the world economy, will catch a cold. For stewards of long-term capital, the sustainability of the flood of Treasury issuance cannot be ignored.
The question arises: Are asset allocators worried that the end is nigh for the Treasury market — and should they be?

“I worry about everything,” says Christopher Ailman, chief investment officer of the $234 billion California State Teachers’ Retirement System (CalSTRS). “I’ve worried about the U.S. deficit — I remember discussing it with my fixed income manager in the 1990s. And it’s done nothing but gotten bigger.”
“I think the most profound impact of all of this, which does get lost on the average American, is that the United States is a debtor nation,” explains Ailman, who manages the assets of the second-largest public pension plan in the United States. “We owe people money. And when the borrower owes money to a lender, you are usually subservient to and at the mercy of that lender.”
“At some point, maybe not in my lifetime,” Ailman says, “being a debtor to other people is going to come home to roost.”
“We’ve thought about it and talked about it,” says Carrie Thome, chief investment officer of the $3 billion Wisconsin Alumni Research Foundation (WARF). “For CIOs, there is no easy answer. What we’re trying to do is continue to be diversified, especially geographically.”
“But there is nowhere to hide,” she says.
The chief investment officer of the $65 billion Alaska Permanent Fund, Marcus Frampton, agrees: “It’s a topic of conversation internally. It is probably one of the more concerning factors out there.”
“I definitely worry about that,” says Jim Dunn, the chief investment officer and chief executive at Verger Capital Management, an outsourced-CIO firm that manages about $2 billion on behalf of several entities, including Wake Forest University’s endowment. “If I’ve learned anything in my career, it’s that credit is unstable. When credit cracks, it causes really big problems — serious booms and busts.”
“If we can’t rely on the U.S. government to manage its credit challenges, there’s nothing left,” says Dunn. “We have nothing to fall back on.”
Such fears are not confined to domestic investors. The $73 billion Ontario Municipal Employees Retirement System (OMERS) highlighted “rising public indebtedness” in its 2018 annual report as one of the trends that “will increasingly weigh on economies.”
Asset allocators worldwide are massive holders of U.S. Treasuries. While they may well decry rising public debt in dry minutes and white papers, they are much less eager to be quoted negatively on the asset class. GIC — Singapore’s sovereign wealth fund, with an estimated $390 billion of assets — pointed to “elevated debt” as one of the “structural headwinds” that it anticipates will significantly reduce its future returns, according to the fund’s 2017-18 annual report. But neither GIC nor OMERS would respond to this reporter’s inquiries.
The fact is these fears have not stopped institutional investors from lapping up Treasuries. As the world’s most liquid asset, Treasuries grease the skids of financial markets and are indispensable to both physical trading and trillions of dollars in derivatives notional. Treasuries also represent the world’s safest of safe havens; backed by the full faith and credit of the most powerful nation on earth, Treasuries were one of the few assets that materially appreciated during the 2008 financial crisis.
But much Treasury buying is mechanical. Fixed income benchmarks are market-value weighted, meaning the largest issuers represent the largest portion of the index. As a debtor issues more bonds, it takes up that much greater a share of the index. Institutional investors, seeking to minimize their tracking error against their benchmarks, then buy that debt without even thinking twice about it.
The changes in the composition of the Bloomberg Barclays Global Treasury Total Return Index, a commonly used global government bond index, illustrate this phenomenon. At the end of January 2009, Japanese government bonds held the plurality, representing almost 35 percent of the index, while Treasuries were in second at 20 percent. Fast forward to April 2019 and Japan and the United States have traded places: Treasuries increased by half to more than 30 percent of the index, while Japan fell 6 percentage points to 28 percent. Unsurprisingly, the portion of the index made up of relatively disciplined borrowers, like Germany, the Netherlands, and Sweden, decreased during this period.
The extent of the Treasury buying is striking. The experience of the world’s largest sovereign wealth fund — Norway’s $1 trillion Government Pension Fund Global — is representative. At the end of the first quarter of 2009, the fund held $12.6 billion of U.S. Treasuries and only slightly smaller positions in German bunds and U.K. gilts. Ten years later, the fund owned $75 billion of Treasuries, more than three and a half times larger than its second-largest bond holding, Japanese government bonds.
The sovereign wealth fund’s 2019 first-quarter report noted that U.S. Treasuries accounted for almost a fourth of its fixed-income portfolio, “making them the fund’s largest holding of government debt from a single issuer” — and representing the highest proportion in at least ten years. A spokesman for Norges Bank Investment Management, which manages the fund, declined to comment for this article.
As America’s public debt piles up, many have wondered when the music will stop. Some of the smartest investors have questioned the sustainability of U.S. fiscal policy, and several have gone so far as to short Treasuries.
Nassim Nicholas Taleb recommended in February 2010 that “every single human being” bet on a collapse in Treasury prices. In April 2010, Bill Gross predicted that interest rates and inflation would spike due to the record issuance of U.S. government debt, and positioned the PIMCO Total Return Fund to take advantage of this eventuality. Julian Robertson made the same call in 2009, anticipating significant inflation that would hammer long-dated Treasuries. John Paulson, also reaching a similar conclusion, in 2009 went long gold as an inflation hedge. Each of these bets proved ill-founded.
There’s a reason rates traders sometimes refer to the short Japanese government bond trade as the “widowmaker.” To short U.S. Treasuries is to array oneself against the most powerful institutions in the financial world, and given the vast size and specialness of the Treasury market, there exists no single mechanism that can force prices to correct. It is little wonder that few high-profile investors have followed in the wake of the missteps of Gross, Robertson, and Paulson.
But given the experience of the last 15 years, it may be worth asking if there’s anything to fear in the first place.

It’s the $22 trillion question: Were Orszag and Rubin premature 15 years ago, or were they just wrong?
An increasing number would argue for the latter. To the advocates of Modern Monetary Theory — Stephanie Kelton, a professor at Stony Brook University and an adviser to Senator Bernie Sanders, most prominent among them — the only problem with the U.S. debt and deficit is that they are not big enough. In a recent interview, Kelton said, “I am driven absolutely to madness by . . . people talking about the deficit as this terrifying thing.” Softer versions of this argument have more mainstream backing, and they boil down to the idea that in the current low-rate, low-inflation environment, it makes sense for governments to keep issuing debt. And the U.S. government, backed by the world’s largest economy and printing the world’s reserve currency, has more room to run up its debt load than anyone else.
The siren lure of this view is obvious. Of those seduced by it you can count America’s political leadership. As three successive presidential administrations have increased the public debt, the most prominent critics of deficit spending have receded. Lawrence Summers, another of Bill Clinton’s Treasury secretaries and Obama’s director of the National Economic Council, has called for Washington to end its “debt obsession.” Even Mick Mulvaney, President Trump’s director of the Office of Management and Budget and an erstwhile deficit hawk, has conceded that “nobody cares” about the deficit. The dueling trillion-dollar spending plans of the Democrats vying for their party’s 2020 presidential nomination underscore the bipartisan consensus on this issue.
And yet surely the laws of macroeconomic gravity have not lost their pull? It’s a question increasingly being asked in academia, at the very least.
“Countries with credible institutions have more leeway to increase their debt than we once thought,” says Randall Kroszner, a professor of economics at the University of Chicago Booth School of Business and a former governor of the Federal Reserve System. “But you don’t want to test how far you can go.”

There are two fundamental reasons why rates have remained low despite the flood of government debt, explains Kroszner, who also served as a member of President George W. Bush’s Council of Economic Advisers. The first was the concerted actions of central banks during and after the 2008 financial crisis to drive down rates, including both traditional rate adjustments and quantitative easing. Overstuffed balance sheets and political backlash may mean such expedients lose their potency going forward. The second is more secular: the global savings glut.
The theory of the global savings glut holds that over the last few decades, the supply of global savings has increased faster than its demand. A host of factors have fueled this shift, but the biggest driver is demographic — an explosion of young workers who saved their earnings instead of spending them, with the Chinese leading the way. This surplus of savings means that inflation stays muted and government bonds can offer low yields and still attract investors.
But the global savings glut will not last forever. “These factors will start to reverse,” says Kroszner. “On a five- to ten-year horizon, you will start to see demographic factors of aging populations reduce savings and change the fundamentals of real rates.” As China rapidly ages and workers start to spend down their savings, rock-bottom rates may not be long for the world.
Rising rates transform a manageable debt load into something malign. Already, the Congressional Budget Office projects the debt service — or what the Treasury pays in interest to its debt holders — to outstrip what it spends on Medicaid next year. If global demographic shifts raise that burden further, the economic and political blowback could be considerable.
There is one other complication that cuts against the reversal of the global savings glut: The rest of the world looks so much worse. Pick your metaphor — cleanest dirty shirt in the laundry, healthiest horse at the glue factory — but staggering public indebtedness and negative yields in Europe and Japan make U.S. Treasuries look good by comparison.
“We’re the highest-yielding debt of all the developed markets right now,” says CalSTRS’ Ailman. “We’re higher than Europe and Japan. We’re attractive.”

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How long one effect can balance out the other will determine the timing of what comes next.

Asset allocators live and die by the markets, and how the Treasury binge plays out is no mere academic concern for them.
History provides some guide as to what could follow. A 2010 report by the McKinsey Global Institute outlined four archetypes for past episodes of sovereign deleveraging: austerity, high inflation, massive default, and growing out of debt. Unfortunately for the optimists, McKinsey identified only one instance of the lattermost: that of the U.S. during the Second World War. So, pick your poison from the first three: grinding belt-tightening, hyperinflation, or default.
To this unpleasant menu you can add another possibility provided by the Japanese. Japan’s government debt is more than twice the size of its economy, but yields are as low as ever. Japan’s economic growth and financial market performance have been anemic for decades, but the country has so far coped with its mushrooming debt load. Importantly, Japanese debt is almost entirely held by domestic investors — by some estimates as much as 95 percent — and Japanese society is homogenous. Whether the American public would so willingly accept low yields and the painful fiscal trade-offs that accompany this path (or whether it should want to) is harder to predict.
For allocators, a key calculation is when the public debt wave will start to crest.
For now, the consensus seems to be that any dénouement is some ways off. The American economy is flourishing, the dollar is still the reserve currency, and Europe and Japan make America look like a beacon of fiscal probity. If the public debt story unfolds without any surprises, in other words, we’re years away from the agony of deleveraging. But the surprises are what worry allocators.
The biggest fear is political.
“We’ve seen the hiccups in the Treasury auctions when we’ve played politics with our budget deficits and raising the debt ceiling,” says CalSTRS’ Ailman. “Suddenly, for the first time people said, ‘Wait a minute, you’re saying this credit might not pay?’”
The Federal Reserve — because of the market’s dependence on it and what it can and cannot do during the next recession — looms large in many minds.
“There’s really not a lot of backstop for a downturn,” says Verger’s Dunn. “We saw a huge downturn in the fourth quarter [of 2018] based on the Fed saying one thing. This is a scary, fragile market. It gets crazy at the end of the cycle.”
Like Chekhov’s gun, others worry about the return of the one threat that has so far been silent: inflation.
“The growing federal debt and quantitative easing are all forms of money printing,” says Alaska Permanent’s Frampton. “I think that the really dangerous situation in the markets is if inflation picks up and the Fed has to respond.”
“[Federal Reserve Chairman] Jerome Powell appears willing to do whatever it takes to not let the stock market go down,” continues Frampton. “But the Fed’s Achilles’ heel is inflation because they wouldn’t be able to react to these other problems out there.”
Inflation seems like a relic from another era, and its total absence over the last decade has puzzled economists. But inflation is a lever that governments can pull to ease their debt burdens, one that Milton Friedman called “irresistibly attractive to sovereigns.” Given that the vast majority of Treasuries outstanding are nominal, the temptation to inflate them away could be compelling. For allocators with real spending needs, however, such inflation would be ruinous.
“Inflation crushes investors, especially institutional investors,” says Verger’s Dunn.
Even without a crisis, however, the prognosis could be grim. At the current tempo, America’s burgeoning public debt load will eventually start distorting the allocation of credit in the economy and necessitate higher taxes — all of which will gradually strangle the markets.
“It’s probably one of those pernicious things,” says WARF’s Thome. “There’s no crash. It’s just a slow bleed of low returns and slow growth. Maybe there’s a malaise that enters.”
“For a lot of people,” says Thome, “the perspective should be worrying about long-term growth as much as anything.”

The cold truth is that immunizing a portfolio against an American public debt crisis is simply not an option.
However, there are tactical and strategic steps that asset allocators are beginning to take to minimize the potential damage.
“People are already rethinking fixed income,” says CalSTRS’ Ailman. “Historically, fixed income has been your anchor to windward — the key diversification in your portfolio. Endowments now have fixed income in the single digits. And a lot of [public] pension plans that were as much as 50 percent fixed income in the 1970s are now generally at 20 percent, maybe 25 percent, and some of them lower than that.”
Alternatives may provide one replacement. “There are a lot of fixed income surrogates, though they’re not as liquid,” says Ailman. “Things like infrastructure and lease payments. Think about a AAA-rated lease payment in Germany as a surrogate for the German bund.”
Others are also turning to alternatives as a port in the storm.
“We do a lot of hedging here,” says Verger’s Dunn. “We’ve done things like alternatives and long-short managers and short-only managers. And we’ve invested in commodities.”
“We’re heavy in macro hedge funds,” says Alaska Permanent’s Frampton. “Those managers have the flexibility and the skill set that we don’t necessarily have in-house here to navigate economic waters that are different than what we’ve seen in the recent past.”
There’s a human tendency to always fight the previous war, and this maxim applies to investing as well. Much mean-variance optimization and scenario analysis rests on the assumption that Treasuries function as the supreme risk-off asset, as they did in 2008. But there is no guarantee that that will be the case.
“My concern is that investment-grade fixed income and Treasuries may not be such a valuable portfolio tool in the next downturn,” says Alaska Permanent’s Frampton, pointing to an unexpected inflationary spike as a scenario in which those assets could underperform. Frampton adds that in his personal account he holds gold — “a fantastic monetary asset which has the same purchasing power today as in the Roman Empire” — but which is not an option for the fund itself.
More broadly, asset allocators must question how different the future will be from the past.
“Government bonds are in the portfolio because they’re the risk-off asset largely and they’re designed to perform when equities are not performing,” says WARF’s Thome. “You have to ask what would stop them being that asset.”
The reality, however, is that few investments will be unaffected if the Treasury market begins to short-circuit. The hundreds of billions of dollars in risk-parity strategies that rely on leveraged fixed income, the trillions in private equity investments in companies dependent on the private debt market, the sprawling derivatives marketplace — all are vulnerable to Treasury turmoil.
“There’s not a lot you can do here as far as asset allocation,” admits Verger’s Dunn.

There has been no shortage of those, like Rubin and Orszag in 2004, who have claimed that the four horsemen are ready to descend on the Treasury market.
Yet Rubin and Orszag themselves recognized the difficulty of predicting the fiscal future. In their white paper, the pair argued that the Congressional Budget Office’s projections of the U.S. debt and deficit over the next decade were much too rose-colored. Based on their own assumptions, they reckoned that the federal debt could grow by as much as $5 trillion over the next ten years, five times higher than the government’s experts had estimated.
“Despite the difficulties of predicting the precise effects or timing,” wrote Rubin and Orszag, “the risks of financial and fiscal disarray associated with large budget deficits may be a much more important motivation for fiscal discipline than merely avoiding the costs of budget deficits suggested by conventional analysis.”
Rubin and Orszag got it wrong. The real tally over the following decade would be twice as much as they predicted. It continues to grow today: Assuming you read at an average pace, the federal debt increased by $28 million since you started this article.