De-Leveraging: The Secret to US Economic Resilience?

by | July 17, 2023

This past week, markets rejoiced at the prospects for a ‘soft landing’ of the US economy. Stocks
and bonds rallied strongly. The catalysts were better-than-expected consumer and producer
price inflation reports, which have lifted hopes that US inflation can be vanquished without

For many, the surprise is not falling inflation, but rather the resilience of the US economy. After all, peak inflation has been long predicted—if perhaps prematurely. Falling oil, food, and other commodity prices following last year’s war-related spikes have long presaged a slowing of 2023 headline inflation. More broadly, comparisons today to last year’s elevated prices were inevitably going to moderate year-on-year inflation measures. Temporary pandemic-related shortages of computer chips, new cars, and other goods have been receding, giving way to higher production and lower prices. And, finally, an observed moderation of market rental rates in the first half of 2023 will predicably feed through into diminishing shelter inflation, the chunkiest component of US consumer price indices.

Soon, US headline consumer price inflation will dip below 3% and it is entirely feasible that core measures of inflation will fall to within striking distance of the Fed’s 2% target by this time next year.

But while many economists agreed inflation would eventually be tamed, fewer thought it could be done without a recession. Aggressive Fed rate hikes, fading pandemic-related fiscal spending, and moribund growth in Europe, Japan and China were seen by many as insurmountable headwinds for the US economy. Bond markets were sending the most powerful signal of all—a deeply inverted yield curve, which is typically the single-best harbinger of a forthcoming recession.

But the latest economic figures belie US recession fears. The labor market continues to create new jobs. Even at its more moderate recent pace, jobs growth is more than twice the growth of the labor supply. Consumer spending, particularly on services, is proving resilient. Even patches of earlier weakness, such as in residential housing, have exhibited renewed vigor. 

To be sure, trouble spots are also visible. Above all, commercial real estate is in a funk, a casualty of higher borrowing costs and a slow return by many workers to the office. Business investment spending is also weaker than overall final demand. Net exports are a drag on US economic activity.

Still, the main story is one of resilience, particularly in the face of the largest Federal Reserve interest rate hikes in a generation (accompanied by similar moves in emerging and other developed economies).

Several factors, some of which we have written about before, help explain the economy’s refusal to roll over, among them steadfast consumer spending fueled by a stockpile of household savings hoarded during Covid lockdowns, the partial replacement of Covid fiscal stimulus with other government outlays (e.g., subsidies for renewable energy in the Inflation Reduction Act), and the surprising resilience of the Eurozone economies to Russia’s invasion of Ukraine.

But another factor, little commented upon in much reporting about the US economy, may also be at work. Specifically, owing to changes in household and corporate borrowing since the global financial crisis (GFC) of 2008, US private sector spending may be less interest rate sensitive than is commonly believed. If so, the Fed’s rate hikes may not be sapping as much demand from the economy as would have been seen in the past.

Little noticed de-leveraging
Since the global financial crisis, US households and creditors have made significant changes in their attitudes toward borrowing and lending.

For instance, from the end of 2007 (the eve of the global financial crisis) to the end of last year, the stock of US household debt, as a percentage of US GDP, has fallen by a quarter, from 101% to 77% of GDP. Notably, that decline in household indebtedness has occurred despite a prolonged period of very low interest rates, the opposite of what might have been expected.

Partly, that was an understandable response of US households to the massive dislocations in housing, labor, and financial markets during the GFC and ensuing ‘great recession’. But lending decisions have also been important. Banks and other mortgage lenders tightened credit standards, for example all-but removing ‘subprime’ from the home lending lexicon. Adjustable rate and interest-only mortgages all but disappeared, with borrowers reverting to longer-term fixed rate forms of housing finance. The home equity loan market scaled back as well.

In short, prudence and restraint—by borrowers and lenders alike—have reduced the stock of household debt to income and have led to a greater use of longer-dated, fixed rate borrowings. As a result, today housing debt is less sensitive to interest rate fluctuations than it was prior to the financial crisis.

The past fifteen years have also witnessed a decline in the amount of money Americans must set aside to service their debt. The household debt servicing ratio has fallen steadily from 13.2% of disposable income in 2007 to 9.6% at the end of the first quarter of 2023. While falling interest rates have been important to that outcome, they only account for part of the decline in debt servicing costs. To wit, as the Fed hiked rates by 5 percentage points over the past 18 months, household debt-servicing costs only rose by 1.5 percentage points of disposable income. That is considerably less than would have been the case if the total stock of debt were at pre-GFC levels and if the fraction of adjustable-rate borrowings had not fallen sharply over the past fifteen years.

For business, similar if more modest dynamics are also apparent. Prior to the GFC total US corporate debt securities and loans, as a share of GDP, peaked at 45%. Today that figure is 43%.

Corporate debt as a share of corporate net worth is now at fifty-year lows. That is the opposite of what one might expect, given the super-low interest rate era from 2010 to 2022 and the simultaneous robust expansion of credit opportunities offered by corporate bond and private credit markets over those years. On average, the data suggest that corporate borrowing has been restrained, not excessive, in recent years. 

Since the GFC, the average maturity of business credit outstanding has also lengthened. Partly, that reflects the demise of short-term commercial paper markets during the GFC, with a shift toward greater reliance on longer-term bond issuance. That was a logical corporate finance response to the significant rollover and liquidity risks companies had faced during the GFC.

Altogether, debt servicing costs for the corporate sector will probably rise over time owing to higher interest rates, but the lags between higher rates and the squeeze on corporate cash flows is probably longer than in prior cycles. 

The public sector
The largest increase in indebtedness over the past fifteen years resides in the public sector. The US government debt to GDP ratio has roughly doubled from 64% in 2007 to 120% at the end of 2022.  

But unlike the household and corporate sectors, the US federal government is not cash constrained. High levels of indebtedness and even rising debt servicing costs, alone, are unlikely to either precipitate a credit crunch by lenders or a rapid policy shift to reduce government deficits and debts.

The evidence for the former is in plain sight. While the Federal Reserve has hiked short rates 500 basis points in the past 18 months, longer-term borrowing rates have risen by only 350 basis points, even as the Fed has announced and initiated a reduction of its balance sheet holdings of Treasuries. Private sector demand for US debt securities remains robust and unlikely to change, despite rising government indebtedness and debt servicing costs.

As for policy, divided government in a polarized political environment all-but assures the continuation of the status quo, with no major policy legislation passing Congress and becoming signed into law. Accordingly, a sudden or sharp fiscal consolidation appears highly unlikely until after the 2024 elections, at the earliest.

Soft landing?
So, is a soft-landing assured? 

No, stuff can still happen. But the risks of a harder landing precipitated by aggressive Fed tightening are receding. Mainly, that is because inflation is finally behaving as most economists thought it would. But a contributing factor is a US economy that is more resilient to higher interest rates than many thought possible.

About the Author

Larry Hatheway has over 25 years’ experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, a non-profit offering commentary and analysis on the global economy, matters of public policy, and capital markets. Larry is also the founder of HarborAdvisors, LLC, an investment advisory firm catering to family offices and institutional clients worldwide.

Previously, Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making, and multi-asset investment strategy.

From 1992 until 2015 Larry worked at UBS Investment Bank as Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). Larry is widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN, and other media outlets. He frequently publishes articles and opinion pieces for Bloomberg, Barron’s, and Project Syndicate, among others.

Larry holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and resides with his wife in Redding, CT, alongside their dog, chickens, bees, and a few ‘loaner’ sheep and goats.

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