The FED raised interest rates above 5%, yet the US economy is not broken. The bond yield curve has been inverted since 2022 and has remained inverted ever since. The lags looked short, with the US economy only briefly causing concern in 2023 when there was a consensus among market participants that a recession would occur.
Something still broke in the markets (regional banks), and yet nothing actually happened. High interest rates are supposed to break something, because an over-indebted economy will have to service a mountain of debt with expensive interest rates and will therefore have less money for revenue and spending.
The problem is that people are looking at the “wrong” debt
Private sector debt levels and trends are much more important than public debt. Unlike government, the private sector cannot afford to print money: if you go into debt and lose your ability to generate income, the pain is real.
The biggest financial crisis happened as a result of high and growing private sector debt. The bursting Japanese or Spanish real estate bubble, the Asian tigers or China today are clear examples.
And that’s why we need to look at debt service ratios.
Debt service ratios measure the amount of disposable income used by non-financial corporations and households to service their outstanding payments.
This is a critical indicator because it effectively shows the pass-through of monetary policy tightening to the private sector. The US debt service ratio is rising slowly: it is at 15% which is equal to its long-term average.
Indicators
There are really four ways that debt service ratios can rise quickly:
- The economy is facing a mountain of private sector leverage.
- A large percentage of private sector debt (mortgages and corporate bonds/loans) is serviced at floating rates, so when the Central Bank tightens, households and businesses immediately face higher debt servicing costs.
- Much of the private sector debt operates on interest rate resets, so in the short term all this debt will have to reset at higher interest rates.
- A large percentage of private sector debt “expects” notional refinancing soon (eg, a large maturity wall).
It’s safe to say that the US doesn’t have many of these 4 problems:
- private sector debt as a percentage of GDP is lower than in 2007;
- mortgages are mostly at fixed rates and
- deadlines are late.
But what about other countries?
Some of the world’s largest economies are under pressure: Debt Service Ratios are at high absolute values – higher than the average of the last 20 years, and the trend is also negative, as they have been rising year-on-year.
For example, Sweden just cut interest rates under pressure from higher debt service ratios. In contrast, the US has a more reasonable private debt-to-GDP ratio (~150%), and its private sector will take longer to feel the pain from higher interest rates.
Think back to the US in 2007 and how different the US economy is today. Then the housing market was hit by the pressure of excessive private sector leverage and the Great Financial Crisis followed.
Today, the story is different: the scale of government deficits (orange) is huge, but private sector credit (blue) is not roaring.
Private sector credit is not the source of excessive money creation and volatility – the US private sector has been effectively deleveraged since 2008!
Instead, today it’s all about government deficits. And in short, that’s why high interest rates and an inverted yield curve haven’t broken the US economy yet. However, slowly but surely, some cracks are appearing under the Financial System:
If someone loses their job, it will be very difficult to find another in a short period of time.
The share of US permanent job losses as a percentage of the total labor force is increasing (see chart above):
Companies facing refinancing rates of 7-8% on their loans/bonds are cutting spending and slowing hiring, thus cooling the labor market.
The US economy is not broken so far. But if the FED keeps interest rates high long enough, it will eventually succeed.
