What would a U.S. debt crisis look like? Citi economist answers most pressing questions about $26 trillion Treasury market.

During the opening lines of the report, the Citi team shared an ominous conclusion: The world won’t know how much debt is “too much” until it is too late.

“As debt levels rise, we have no way to predict danger thresholds or the amount of debt that is simply ‘too much.’ But it’s unwise for policymakers to experiment or test where these thresholds might be,” the team said.

“In our view, the prudent path for fiscal policy is, at a minimum, to not push debt further upward from today’s elevated levels. Even so, we have little hope of meaningful remedial action in the foreseeable future.”

But the U.S. government still has options to rein in debt issuance before it risks spiraling out of control.

Here are some of the questions they answered.

How high is the debt relative to history?

The U.S. debt burden has grown substantially since the beginning of the COVID-19 pandemic.

U.S. federal government debt as a percentage of GDP has risen from 80% — already high relative to history — to nearly 100%, according to Citi’s calculations. It currently sits at its highest level since the 1940s.

At this point, it is virtually guaranteed that debt-to-GDP will surpass its previous post-World War II peak. As the chart above shows, the ratio is projected to rise to 115% over the next decade. The Congressional Budget Office projects deficits will likely creep higher, with the U.S. expecting a cumulative deficit of roughly $20 trillion.

Is increasing supply really a concern for bond investors?

Concerns about Treasury supply intensified over the summer following Fitch Ratings’ decision to strip the U.S. of its AAA credit rating. That decision was followed in short order by one of the Treasury’s quarterly refunding announcements, where an increase in debt-issuance projections caught the attention of bond bears.

Although concerns about Treasury supply have featured prominently in commentary from high-profile investors like Bill Ackman and Paul Tudor Jones, the team at Citi sees it as more of a side show for the market.

Instead of supply driving the market, they believe a rising term premium and data on the U.S. economy are exerting the most influence on bond yields and prices, as Federal Reserve Chairman Jerome Powell also said.

See: Bond traders see ‘green light’ to push up yields after Powell remarks: Fed watcher

“…We do not see strong evidence that supply is the primary driver of yields; rather we think of supply being an additional factor, with the main driver being the projected strength of the economy into the future, and the expectation of a higher neutral rate in the economy. In recent months, the term premium — the extra compensation investors require to hold a long-term bond instead of a series of short-term bonds—has risen, which is due to a combination of these factors,” the Citi team said.

What would a responsible reduction look like?

It’s hard to say, according to Citi.

The biggest problem, according to them, is that neither Democrats nor Republicans appear willing to cut spending. While Democrats have pushed to raise taxes, Republicans are more focused on cutting them, or preserving previous tax cuts enacted under former President Donald Trump.

Entitlements, most notably social security, represent the biggest slug of the U.S. budget, but defense spending’s share isn’t miniscule.

“On the spending side, most federal expenditures consist of defense and entitlement spending that is politically difficult to set on a downward trajectory. Entitlement programs (‘mandatory spending’) make up about two-thirds of all federal spending, but any changes would likely be phased in slowly (e.g., raising the social security retirement age or reducing Medicare benefits). Of the remaining ‘discretionary spending,’ almost half goes toward defense which, given geopolitical events, is unlikely to be pared back any time soon.”

It’s likely cuts to entitlements and defense would be needed to reform spending.

“In our view, an adequate remedy will require some combination of both higher taxes and reduced expenditures. Notably, getting traction on expenditures is likely to require tough reforms to entitlements and defense, which comprise roughly three-fourths of federal spending,” the Citi team said.

What would a full-blown crisis look like?

The U.K. gave the global bond market a taste of what a sovereign debt crisis in an established developed-market might look like last year when then-Prime Minister Liz Truss’s mini-budget sent the gilt market reeling. Volatility in the British bond market rippled out through other markets, including U.S. Treasurys.

The good news is that swift intervention by the Bank of England managed to quell the crisis, despite what Citi described as a “perfect storm” that “seems unlikely to be replicated elsewhere.”

See: Bank of England official says $1 trillion in pension fund investments could’ve been wiped out without intervention

The bad news? You don’t now what you don’t know, and the last decade has produced many surprising developments that have thrown a curve ball to global markets, from the unexpected Brexit vote.

“As such, we interpret the UK gilt crisis as a cautionary tale for both the UK and other countries in the years ahead,” the Citi team said.

Treasury yields have pulled back over the past two weeks, with the 10-year yield
BX:TMUBMUSD10Y
down 41.7 basis points from its 52-week high of 4.987% from Oct. 19, according to Dow Jones Market Data. Meanwhile, the yield on the 30-year
BX:TMUBMUSD30Y
is off 36.7 basis points from its 52-week high of 5.101%.