Insights & Thoughts

A House Divided

by | Oct 17, 2023 | Market Related, Quarterly Commentary

Earlier this week, the House of Representatives voted to remove Kevin McCarthy as speaker of the House.  While there has been no shortage of opinion and commentary in the media about this, one thing is clear, the revolt by a handful of Republican congressmen was largely about spending and the deficit.  What is astonishing to us is that of the 535 congressmen, apparently only 8 seem to care about the nation’s debt level.  I guess this is what you get after more than a decade of free money.

Washington has been on a spending spree since the Vietnam war, so deficits are nothing new. What is new is the sheer size of the annual deficits.  Over the last five years, the nation’s outstanding debt has increased by roughly 50% to more than $33 trillion.  No one has paid much attention to this since the financial crisis because the government’s cost of borrowing has been so cheap the whole time.  For much of the last decade, the government’s interest expenses have remained relatively flat below $250 billion per year.  Even with the increased balance in the past 5 years, borrowing costs have only gone up $100 billion per year.  That’s remarkably small considering the growth of the underlying balance.

Now that the era of easy money appears to be over, rates are normalizing at a break-neck pace.  The benchmark 10-year treasury bill is now yielding just under 5%.  In fact, the yields on all maturities are up substantially over the past twelve months and the costs to finance these deficits are adding up quickly.  It’s estimated that interest payments on the national debt will increase 35% this year to $640 billion.  Where is that money going to come from? It’ll be borrowed, of course, and further exacerbate the problem.  For every 1% increase in borrowing costs, the government will spend an additional $330 billion per year in interest, and that number will grow as the balance continues to go up.  It’s not hard to see how things can spiral out of control in the coming years.

At what point does this become a death spiral for the country’s finances?  It’s hard to say, but I’d equate it to smoking cigarettes.  How many is too many?  There is no magic number, but you’ll know when the doctor gives you the bad news, and by then it’s too late.

Let’s be clear about what the root problem is here.  It’s spending and not a taxation issue.  It’s also bipartisan.  Over the last ten years, spending has outpaced the population growth rate by 3 to 1.  That in itself is unsustainable.  At some point, you literally run out of people to tax. Once again, this is an example of what ultra cheap money buys and where bubbles come from.  It’ll be interesting to see what the impact on future budgets will be as interest costs crowd out other priorities.

The only seeming beneficiaries of the chaos are retirees.  We’re finally in an environment where you don’t need an insane amount of money to retire on.  The landscape has so dramatically changed in the past year and a half, that it now takes less than half the savings to generate the same income as it did in 2021.  Historically, six percent has been the long-term average return on corporate bonds and we’re getting pretty close to that number now.  Our latest round of bonds that we’ve bought have had yields in the upper five percent range for securities that wouldn’t have yielded two percent in 2021.

In the equity market, stock performance continues to be closely tied to interest rates and has reacted accordingly.  The S&P 500 has sold off nearly 8% since the beginning of August when we saw an almost hundred basis point rise in the ten-year treasury bill.  Bond yields are now attractive enough that they’re effectively competing with the stock market.  This has led to a significant flow of capital out of stocks and into bonds lately.

Recession fears have been the real headwind to stocks for most of the year.  Both mortgage rates and auto loans are now solidly above 7%, yet the economic data still shows a relatively healthy economy.  Our expectation is that the rate increases will subside by the end of the year.  At that point, we feel the stock market will find a firmer footing and have reason to move higher.  Until then, it’ll likely remain range-bound in a similar pattern to what we saw this summer.


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