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The author is the founder and CEO of Algebris Investments
In the world of finance, trust is the most valuable commodity. As investors, we have come to understand this fundamental truth over time, sometimes through challenging experiences. Trust forms the foundation of every financial figure, from corporate earnings to macroeconomic indicators. It serves as the crucial link between investors and their investments. Rebuilding trust once it has been lost is a lengthy and arduous process.
The incoming Trump administration is assuming office at a time when investor confidence in the United States is strong but showing signs of strain. The collective foreign ownership of US marketable securities currently stands at over $31 trillion, a clear vote of confidence. However, the past three years have witnessed the testing of the boundaries of the post-2008 financial system. Maintaining and reinforcing trust is now more crucial and challenging than ever. The recent market turmoil triggered by tariffs serves as a stark reminder of this.
The management of US debt has become increasingly complex. The federal debt held by the public has surged to 100 percent of GDP, the highest level since the postwar era. By comparison, it was a mere 36 percent in 2005. Interest payments now account for 3.2 percent of GDP, double the average of the past decade.
This level of interest burden is reminiscent of the mid-1990s, when interest rates stood at 6 percent. However, back then, the government was running a primary surplus, and overall debt levels were significantly lower. Even the most conservative forecasts anticipate a rapid escalation in public debt over the next decade.
Global investors play a critical role in financing this surge in borrowing. International holdings of US Treasury securities amount to $8.5 trillion, a quarter of the total. Debt inflows from abroad fund 90 percent of the US current account deficit. Both public and total US liabilities heavily rely on foreign demand for US debt securities.
Historically, there is a pattern to debt accumulation. Regardless of the country’s circumstances or prevailing narrative, there exists a tipping point beyond which the risks associated with debt escalation increase significantly. This risk is particularly pronounced when the country as a whole, not just the government, becomes a persistent borrower. Once this tipping point is reached, confidence can rapidly erode, leading to adverse impacts on interest rates and the currency.
While pinpointing the exact tipping point is challenging, there are measures that can be taken to mitigate the associated risks.
Firstly, the US Treasury should demonstrate fiscal discipline to reassure the markets. Despite robust economic growth post-Covid, US spending has failed to return to pre-pandemic levels. Primary deficits have stabilized just below 4 percent since 2021, with a growing social security burden and limited action on discretionary spending. Moreover, the cost of US debt remains below market rates, providing little relief in terms of interest expenses.
The anticipated extension of the 2017 individual tax cuts by the Trump administration will be a critical litmus test in this regard. The Congressional Budget Office estimates that this move could result in $4.6 trillion in lost revenues over a decade, a figure that may unsettle the markets.
Secondly, US policy should be characterized by predictability. Since taking office, global markets have been grappling with uncertainty surrounding the country’s strategic direction. Conflicting statements from the president and key officials on trade, fiscal, and regulatory policies have only added to the confusion. This lack of clarity has not only unnerved markets but also left Main Street in a state of flux. The market volatility following tariff announcements underscores this point.
Policy uncertainty indices in the US are currently hovering near record highs, with only 2020 registering higher levels. This uncertainty is unwarranted, considering that the US is not facing an acute crisis. Predictability is a simple yet effective strategy that yields a high return in terms of market confidence.
Thirdly, international relations should be managed with finesse. As the world’s preeminent power, the US naturally seeks to leverage its position to secure concessions from its allies and partners. However, recent rhetoric has revealed an excessive reliance on US leverage, overlooking the fact that the world also depends on America.
This perspective holds true only as long as global investors continue to finance the US’s expanding deficits. Aggressive diplomacy and protectionist measures risk alienating partners, potentially leading to reduced foreign direct investment and a dearth of buyers for US assets, if not outright divestment. This runs counter to the US’s interests.
For decades, the US has enjoyed the benefits of a strong currency and low interest rates compared to its economic fundamentals, in exchange for providing the world with secure assets. Economists refer to this as the “exorbitant privilege.” However, every privilege comes with responsibilities. In the realm of global finance, trust is the ultimate currency. It is imperative for America to safeguard this currency from depreciation.