Treasury Secretary Janet Yellen made news last week when she said that “if [government] debt is stabilized relative to the size of the economy, we’re in a reasonable place.” Now on first glance, this seems impossible. How can one think that $34 trillion of government debt is stable?
What is consequential here isn’t Yellen’s statement about debt, though. It’s what she said after. “The way I look at it is that we should be looking at the real interest cost of the debt. That’s really what the burden is.”
I hit on this argument before here on InvestorPlace.com, and it’s worth repeating since Yellen just told us why precisely the Federal Reserve must lower rates. The real interest cost of debt.
The risk isn’t the nominal amount of debt that’s outstanding, but that inflation is not higher than the cost of servicing that debt. Now none of this should come as a surprise. But the reality is this is a pretty blatant admission that the government has no intention of ever paying off its loans other than by kicking the can down the road.
I think this is why long-duration Treasury yields are falling.
Fed Chair Jerome Powell is talking a tough game about keeping rates elevated until there is more “confidence” that inflation gets down to 2%, but he knows his marching orders. He may want to keep rates elevated, but the reality is that he will bow to the pressure of needing to reenter a negative real rate environment where inflation is higher than the cost of capital needed to literally bail out the U.S. government.
How to Invest Ahead of Lower Interest Rates
This brings with it an interesting dynamic from an investment perspective. If Yellen is alluding to the idea that it’s only a matter of time until we reenter a negative real rate environment, then the investment play that would most benefit is commodities. Real assets are typically the big winners when inflation is eroding interest expense on the bond side because real assets are scarce. This could be precisely what investors in gold are getting ahead of.
Either way, I think it’s clear that lower rates are coming, even if the inflation fight isn’t done. The government needs cheaper capital and will do whatever it takes to get it through inflation instead of outright taxation.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
