One might think that a staggering debt load would be destructive to the economy. However, the U.S.'s $28+ trillion Federal debt could be the primary catalyst for higher stock and risk asset prices. There is a lot of talk about inflation and interest rates lately. "Inflation is running hot these days," some say. "When will the Fed start to tighten monetary policy?" others ask. Yet, the elephant in the room (the Federal/public debt) rarely gets mentioned. My question is, how is the Fed going to raise interest rates when higher rates could make our government debt burden unsustainable?

The Debt Problem

The U.S. has a Federal debt to GDP ratio of 128%. That is relative to just 58% in 2000, and 35% in 1980. The United States now has one of the highest debt to GDP ratios in the world. Why is this a problem? It's not, so long as you keep interest rates extremely low.

Let's Look at Japan for Context

Japan is one of the world's most developed economies and has the highest debt to GDP ratio out of any nation.

Japan's Debt/GDP %

Source: tradingeconomics.com

The U.S.'s debt burden is around 128% of GDP, yet Japan's towers at over 250%. How has Japan maintained such a giant debt load without imploding the country's economy?

Japan's Benchmark Rate

Source: tradingeconomics.com

Japan is successful at maintaining such a gigantic debt load due to a multi-decade-long ultra-easy monetary environment. Much like the U.S. in 2008, Japan's financial crisis occurred in the early 1990s. We see that the country's debt to GDP ratio began to climb sharply after this time. Incidentally, Japan's benchmark rate fell to less than 1% and has remained below 1% for decades. We saw a brief attempt to take rates higher around the market top in 2007, but ultimately Japan's central bank needed to bring rates into negative territory to provide growth for the economy.

U.S.'s Debt/GDP %

Source: stlouisfed.org

If we look at the U.S.'s debt to GDP ratio, the image is eerily similar to Japan. The U.S. seems to be around where Japan was in early 2000 relative to its debt to GDP ratio. Also, like in Japan, we can expect the debt to GDP ratio to continue to increase. The U.S. has a remarkably high Federal budget deficit of over $3 trillion ($3.6 trillion, actual). Now, we can expect the deficit to remain relatively high (over $1 trillion) in future years regardless of government fiscal policy. Therefore, the debt to GDP ratio is very likely going to continue to rise.

Fed Funds Rate

Source: tradingeconomics.com

The Fed funds rate has been at 0-0.25% for most of the last 12-year period. We see a brief attempt to bring rates modestly higher in the 2016-2020 time frame. However, this attempt failed, as the economy started to show clear signs of strain in a slightly higher interest rate environment.

U.S. 10-Year Treasury

Source: CNBC.com

Back in the 1980s, when the U.S. debt was at around 35% of GDP, the economy could withstand substantially higher interest rates. However, we see a clear trend here. As the U.S. debt perpetually increases, the 10-year Treasury and other interest rates head lower and lower.

Source: stlouisfed.org

So, there is a clear correlation here. Due to enormous public and general debt obligations, the economy needs ultra-low rates to expand.

How to Prevent a Disaster?

Just look at Japan; the answer is ultra-easy monetary policy. First and foremost, low and eventually negative rates. Japan's central bank took its benchmark rate negative after zero was not enough to service its debt and produce growth. The U.S. is likely heading in the same direction. After all, like any other debt, the Federal debt needs to be serviced. The debt is mainly composed of 5, 10, and 30-year Treasuries. Thus, the lower the Treasury yield, the easier it is to service the public debt. In fact, it is preferable to have the 10-year and other Treasuries as close as possible to zero, or even negative. Therefore, regardless of inflation, we are likely looking at an ultra-easy environment for longer in the U.S. The Fed can attempt to elevate rates modestly from here, but tightening comes with the added risks of throwing the economy into a tailspin and making the debt burden unmanageable.

The Bottom Line

Due to remarkably high debt obligations, the U.S. will likely remain in an ultra-low interest rate environment for a long time. Inflation is heating up, as the last CPI reading came in it at 4.2%. Other inflation readings like the PPI and wage growth are also signaling inflation growth ahead. The Fed is supposed to increase interest rates to combat inflation. However, this will be a difficult task given current economic dynamics. First, the economic environment is still relatively fragile, and any attempt at higher interest rates could derail this economic recovery. Moreover, with over $28 trillion in Federal debt along with multi-trillion dollar deficits, an increase in interest rates would notably increase debt servicing payments. A perpetual disconnect between tax revenues and government spending could make the national debt appear unmanageable. In turn, this could lead to a crisis of confidence. Such a phenomenon would likely reflect very negatively on the U.S. dollar, as well as U.S. bonds, notes, and Treasuries.

Thus, to avoid such consequences the Federal Reserve could follow in the footsteps of the Bank of Japan. Ultra-easy monetary policy for an extended period should take pressure off the Federal debt servicing payments and should enable economic growth to occur. However, we should see elevated inflation for some time. In such an environment, asset prices should continue to appreciate. Therefore, this is likely still a great time to own risk assets like stocks, commodities, digital assets, and other investment vehicles that should outperform negative-yielding inflation-adjusted bonds and other stagnant growth instruments.