1) The US government debt level of nearly $30 trillion poses risks even though low interest rates have kept debt servicing costs low currently. The upcoming expiration of the debt ceiling raises the possibility of a downgrade in the US credit rating or a technical default. 2) A credit downgrade or hitting the debt ceiling without a resolution could negatively impact risk assets, as occurred in 2011. Investors should take a longer term view and pay attention to weakening economic fundamentals rather than just focusing on record high stock markets. 3) The options available to address the growing debt problem like raising taxes or interest rates all carry risks for either the economy, financial markets or the US dollar. The government appears backed into a corner with

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Treasuries continue to tell, what I think, is the real story of the economy. Most people who watch the
market tend to minimize the risks involved in accumulating nearly $30 trillion in debt because 1) large-
caps are still near record highs, so investors have mostly felt little pain and 2) record low interest rates
have made this debt relatively serviceable for the time being. We haven’t heard much about the coming
debt ceiling expiration at the end of this month as rising COVID threats and even infrastructure to a
lesser degree capture headlines. Make no mistake about it though. You are going to hear a lot more
about it soon and that is probably going to put pressure on Treasury rates to go even lower.
It is discouraging that both sides of the political aisle appear to be dug in for now, raising the risk that
this situation could turn ugly quickly. The fact that the terms “extraordinary measures” and “technical
default” and “running down cash balances” and “wiggle room” are showing up more and more in the
financial media indicates that a credit downgrade and the consequences of hitting the debt ceiling
without a resolution are very real and should not be ignored. Risk assets reacted quickly and negatively
in 2011 when this happened the last time. It is possible it could happen again.
If you have not already, it is time to start taking a longer-term view of the financial markets and the
economy. I understand that the Dow, the S&P 500 and Nasdaq 100 are at all-time highs and equity
investors still maintain a healthy amount of bullishness, but it’s time to start paying attention to what
the economic fundamentals are telling us. Wall Street enthusiasts always like to say, “this time is
different”, but mean reversion almost always wins it in the end.
I have been griping about the possibility of a government debt downgrade for weeks now with the
current suspension of the debt ceiling set to expire at the end of this month acting as the catalyst. While
most people agree that an actual debt default is unlikely (even if the debt ceiling is not extended, the

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government still has cash to work with in the meantime and would almost certainly come to a resolution
before a “catastrophic”, as Janet Yellen would put it, outcome were to occur), the odds of a rating
downgrade by one of the major credit agencies is much more likely.
In fact, the rating agency Fitch has had one on its radar for nearly a year now.
Back in 2011, the three major agencies - S&P, Moody’s, and Fitch - placed a negative outlook on
Treasury debt with S&P going all the way as to cutting the rating from AAA to AA+. By 2014, they all
returned their outlooks to “stable” as the immediate debt ceiling crisis passed.
Here is a CNN article on what happened in 2011
Fitch was the only one of the three to flip its outlook back to “negative” during the COVID pandemic. It
cited a deterioration in U.S. public finances as well as the lack of any firm plan to address the growing
debt - a situation that has only worsened as the U.S. debt closes in on the $30 trillion mark with
additional large spending packages, including infrastructure, still on the table.
To understand how the debt ceiling fight could lead to a potential rating downgrade and a dollar
devaluation, it is helpful to look at a step-by-step for how this could potentially play out. Here is what
we know today.

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1. The federal government will soon have $30 trillion in total debt on its books. The average
interest rate on this debt as of the end of 2020 was about 1.7%. That means the government can
be expected to pay just over $0.5 trillion in 2021 alone servicing existing debt.
2. The government takes in around $3.5 trillion in tax revenue annually, so $1 of every $7 taken in
already goes towards interest payments. The Fed plans on leaving interest rates near zero until
at least 2023. Even though the latest dot plot report suggested pulling the rate hike calendar
forward, several Fed governors have worked to calm fears of higher rates by reinforcing a more
dovish rhetoric. Tapering asset purchases could come much sooner, but there is no firm timeline
yet.
3. The 10-year Treasury yield is sitting at just under 1.4%. The current inflation rate is 5%, but it is
expected to come back down to some degree as low base effects and supply chain issues wear
off.
The government used to issue a more balanced mix of shorter-term and longer-term Treasuries to raise
funds. That mix has turned progressively more short-term over the years to help minimize borrowing
costs. From a financial standpoint, that is a good thing, but it makes U.S. debt more vulnerable to rising
interest rates since low-rate debt will roll off the books faster.
That is also reflected in the average interest rate paid on U.S. Treasuries.
The average rate got up to around 5% just before the financial crisis but has been drifting lower pretty
much ever since. The focus on Treasury bill borrowing to fund various stimulus packages has pushed the
average borrowing rate down to around 1.7%. If rates rise and the average interest rate moves back to

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its pre-pandemic level of 2.5%, that adds another $240 billion in interest expense. Suddenly, that $1 of
every $7 in tax revenue going towards interest expense turns into $1 of every $5.
Now, compare that chart to the path of the 10-year yield over the past two decades.
Not surprisingly, the two look similar - rates slowly rising in the mid-2000s and again from 2017-2019.
The problem is that the average interest rate paid curve trails the 10-year yield curve by about two
years. You can see that the 80 basis point rise in Treasury yields over the past year isn’t showing up in
the average that the government is paying for borrowing. In other words, borrowing costs for the
government may be getting ready to go up again just when it needs to focus on debt solutions. Again, a
lot of that borrowing is being done at short-term rates, so there may not be a significant impact, but
still.
You can also see why the government needs inflation to be not permanent and interest rates to remain
as low as possible for a while. With debt spiraling, no good solution in place to solve the problem and
debt balances soon to become unmanageable, there might be no good way to avoid an adverse
outcome. It is just a matter of which one the powers-that-be choose.
Here is what I see as some of the most likely paths the government could take here and what their
potential impacts might be.
Solution: Refinance debt to lock in low long-term rates
Potential Outcome: Create longer-term financial stability, but short-term interest expense rises.
With the government always focusing on the here and now, this choice seems unlikely. On one hand, it
makes a lot of sense long-term because you are essentially locking in a 1-2% borrowing rate for the next
10-30 years. On the other hand, that would also mean the government paying 1-2% more than they

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would have to if they just would have stuck to issuing near-zero rate T-bills. Plus, it would be paying that
interest rate for decades instead of just the next year or less.
This move would help alleviate longer-term pressures once interest rates begin rising again, but it
creates more pressure in the short-term since existing debt would be more expensive to service.
Solution: The Fed raises interest rates sooner than 2023.
Potential Outcome: It improves real yields, and the dollar rises, but it potentially swings the economy
back into recession and hurts risk asset prices.
A cynic like me would argue that the Fed cares about the financial markets first, the economy second
and the dollar last. Plus, there is no guarantee that the government or the Fed even wants a stronger
dollar here. It is easy to make the argument that the current state of the economy no longer warrants
keeping the Fed Funds rate at zero, but the Fed does not want to take the chance at rocking the boat. It
wants to be very careful at telegraphing its moves, so the market is not caught off guard. 2018 should be
a reminder that the Fed would be quick to reverse course if things start to go sideways.
Solution: Keep interest rates low and hope that inflation does not remain hot.
Potential Outcome: The Fed can let the deficit run if it can borrow at near-zero rates. Equities could
continue to do well, but the dollar sinks.
This seems to be the most likely course of action - roll the dice and hope for the best. Near-zero interest
rates help to keep a floor under asset prices, which is a goal of the Fed whether they explicitly state it or
not. The biggest risk is that inflation is here to stay longer than expected. Even if inflation doesn’t stay at
5%, but remains at 3% or so, real yields remain historically low, and the Fed would likely be forced to
raise rates quickly to prevent the economy from overheating. This would be the scenario where both
equities and the dollar likely fall, and the Fed loses its grip on the situation. The phrase “soft landing”
would be the ideal outcome, but who knows if the Fed can pull it off.
Solution: Raise the corporate tax rate.
Potential Outcome: It would help the debt problem and the dollar, but it would come at the expense
of GDP growth and equity prices most likely.
Raising the corporate tax rate is probably the easiest way to increase tax revenues without running the
risk of angering voters. Taking away any political angles, the corporate tax cut enacted under did help
spur economic growth in the short-term, so its reversal would likely result in the opposite effect. An
increase in tax revenues, however, would need to come without a corresponding increase in spending
though. That is something that the government has, so far, shown little interest in.
Conclusion
There are almost no good solutions here. Whichever path the government chooses to take, it is almost
certain either stock prices, the U.S. economy, or the dollar. That is the consequence of focusing on
short-term gain at the expense of the long-term. If there had been a focus on both short- and long-term
solutions, it could have helped minimize the risk of a more painful tail risk event.

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Instead, the government has insisted on historically loose financial conditions and unlimited liquidity to
inflate the bubble to its breaking point. Now, it is effectively backed itself into a corner where it is forced
to try to choose the “least bad” option.
If the ratings agencies are viewing the current environment in the same way I am, I think they at least
have to consider changing their outlook to “negative” or even cutting the rating altogether.
Feel free to use me as a sounding board.
Best regards,
-Kurt
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Direct: 952.828.5336
Email: kurt@ivoryhill.com | ivoryhill.com
8400 Normandale Lake Blvd, Bloomington, MN 55437
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