Testing debt tolerance

The assumption that low interest rates are here to stay is based on a fragile equilibrium as debt rises sharply.


The fiscal policy outlook is very consequential for investors. The consensus view is that the low interest rate regime is here to stay. This is the core justification for current asset valuations and strategic asset allocations. But whether it persists will depend crucially on the interplay between interest rates, inflation and debt.

Then and now
Estimate of covid-19 activity shock discretionary fiscal support compared with the GFC

Covid is one quarter the economic hit than the GFC, but has seen 4 times the response.

Sources: BlackRock Investment Institute, with data from Haver Analytics, February 2021. Notes: The charts show our estimate of the cumulative GDP loss from the GFC (2008-2009) and our expectation for the Covid-19 (2020-2021) and the discretionary fiscal support for the US and euro area during each period.

The policy response to Covid-19 has sparked an unprecedented peacetime increase in sovereign debt. In the U.S., the 2020 fiscal response amounted to $3.3 trillion. Current Covid support approved in late 2020 and proposed spending by the new U.S. administration could add up to another $2.8 trillion to the fiscal bill as of February 2021. And even more is likely on the way in coming years.

This is an enormous fiscal impulse on its own – but also relative to the size and the nature of the Covid-19 shock. We estimate the cumulative activity shortfall in the U.S. and Europe will be a fraction – a quarter roughly – of the global financial crisis (GFC), yet the discretionary fiscal response now is a multiple of the response then – roughly four times. And the objective of policy today is not to stimulate – there is no point stimulating activity that’s been purposefully halted – but to provide a bridge to a post-Covid world. We see a large part of activity restarting on its own once the pandemic is under control even without fiscal support.

Relaxed on record debt

Up to now policymakers, taxpayers and financial markets have been surprisingly relaxed about the large increase in debt. This is a stark contrast to the aftermath of the GFC when the focus quickly shifted to austerity. The fact that debt servicing costs are currently at record lows certainly help justify the relaxed attitude. International organizations like the International Monetary Fund are even calling for expansionary fiscal policy now.

The academic consensus on debt and deficits has also experienced a 180-degree shift over the past decade. After the GFC, the work of Rogoff & Reinhart (2008) provided the intellectual backing to quickly embark on fiscal consolidation and debt reduction. Today, the consensus now finds its backing in the arguments of Blanchard & Summers (2017) and the greater fiscal space created by historically low long-term government bond yields.

The crux: this is not only about low long-term yields but real interest rates being persistently below trend growth  – a topic we first touched on in November 2017. This means that governments can run deficits while still keeping the debt/GDP ratio stable or even reducing it. This might sound like a free lunch, but what it really means is that the consensus now assumes that a growing part of the debt will de facto be repaid by debt holders rather than taxpayers.

Twice the debt, half the cost
U.S. government debt and net interest cost, 1990-2025

U.S. government debt and net interest cost, 1990-2025

Source: BlackRock Investment Institute, IMF and OECD, with data from Haver Analytics, February 2021. Note: Net interest cost shows the interest payments made by the government on the existing stock of government debt. Interest payments are expressed as a share of nominal GDP. For the period 1990-2000 data are from the OECD and for 2001 data are from the IMF. For the period 2021-2025 projections are provided by the IMF October 2020 World Economic Outlook. Forward-looking estimates may not come to pass.

Low-rate regime

The more relaxed attitude towards debt boils down to a belief in an entrenched low inflation and low long-term rate regime, even in the face of new record high debt levels amid rising inflation. The entire logic of the new consensus breaks down if we were to move to a regime of higher long-term yields up to or above growth rates, causing debt to rise even with balanced budgets.

A big driver of this low long-term rate regime has been increased demand for assets seen as safe and liquid, like government bonds, due to heightened uncertainty and risk aversion. Typically, investors demand compensation for risk in government bonds (term premium) – including inflation risk. In recent years they have foregone such risk compensation. The question how much longer this might last given that government bonds have become much riskier as the interest paid in coupons has evaporated, duration has lengthened and overall debt has increased.

Low for now
U.S. debt cost and hypothetical scenarios, 1990-2025

Chart U.S. debt cost and hypothetical scenarios, 1990-2025

Forward-looking estimates may not come to pass. Source: BlackRock Investment Institute and IMF, with data from Haver Analytics, February 2021. Notes: Interest payments are calculated as the difference between U.S. general government net borrowing and U.S. general government primary deficit and expressed as a share of nominal GDP. The first scenario in red shows hypothetical interest costs assuming that the effective interest rate on the existing debt stock rises quickly to 2.5% and holds there over the next four years. The second scenario shows the hypothetical impact of a more gradual rise to 2.5% by 2025. The green line shows the IMF’s October 2020 projections. Hypothetical data results are based on assumptions applied retroactively with the benefit of hindsight, were not made under actual market conditions and, therefore, cannot completely account for the impact of economic risk.

Risk and perceptions

This perception of safety in government bonds has not always been the case –and it could change again. Rising inflation – with record debt levels and nominal yields close to their effective lower bounds – could be the trigger. In this environment, developed market (DM) government bonds are exposed to capital losses and their ballast role in portfolios will be more challenged. Importantly, this is about investor sentiment more than fundamental drivers. Because this is about perceptions and sentiment, this equilibrium is also more fragile. And at high debt levels, smaller shifts in bond yields will have a much bigger impact on debt servicing costs.

We think central banks will initially lean against rising long-term bond yields –and that will likely work for some time. Letting long-term rates rise will be fiscally difficult to absorb – through higher debt servicing costs – and financially disruptive. That is what we refer to as fiscal and financial dominance. This can temporarily head off the self-reinforcing dynamics set in motion by inflation and higher debt levels. But leaning against rising yields will become an increasingly challenging position for central banks over time as inflation rises beyond the new tolerance bands revised policy frameworks.

Bottom line: For now, we think the low long-term real rate regime continues as the dominant narrative, and it is difficult to know when sentiment will shift. This would change if long-term real rates show a sustained return to their historical sensitivity to higher inflation. At that point, we expect central banks to lean against this for a while. This is why we continue to be pro-risk on a 6- to 12-month horizon. But if the narrative around the perceived safety of government bonds changes more fundamentally, it will become difficult for central banks to contain the shift in market sentiment. That is a key reason why we are underweight DM government bonds over a five- to 10-year horizon.

Risk perceptions
U.S. 10-year yield and term premium, 1990-2021

Chart U.S. 10-year yield and term premium, 1990-2021

Past performance is not a reliable indicator of current or future results. Sources: BlackRock Investment Institute and Federal Reserve Bank of New York, with data from Haver Analytics, February 2021. Notes: This chart shows our estimate of the term premium in the U.S. 10-year Treasury note. It is estimated using a term structure model – based on the relationship between short- and long-term interest rates – similar to a New York Fed model.

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Elga Bartsch
Head of Macro Research
Elga Bartsch, PhD, Managing Director, heads up economic and markets research at the Blackrock Investment Institute (BII).
Jean Boivin
Head of BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is the Head of the BlackRock Investment Institute (BII).
Alex Brazier
Deputy Head – BlackRock Investment Institute

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