Sorting Out the U.S. Debt Cycle: Risks, Opportunities, and Reflections

Author: shu fen

The predicament of U.S. debt cannot be resolved in the short term, and ultimately, it will still have to be addressed according to the two paths of the debt crisis mentioned above.

This article references Ray Dalio's new book "How Countries Succeed or Fail," and at the end combines my personal views to outline the opportunities and risks of the U.S. debt cycle, serving only as an aid for investment decisions.

First, let me introduce Ray Dalio—founder of Bridgewater Associates, who has successfully predicted major economic events such as the 2008 financial crisis, the European debt crisis, and Brexit multiple times. He is hailed as the Steve Jobs of the investment world. Now, let's get into the main text.

In the past, when studying debt, it usually referred to the credit cycle synchronized with the business cycle (approximately 6 years ± 3 years), while the long-term debt cycle is more important and fundamental. This is because since 1700, there have been about 750 types of currencies or debt markets globally, but now only about 20% still exist. Even among the surviving currencies, most have experienced severe depreciation, which is closely related to the "long-term debt cycle" discussed in the book.

The core difference between the short-term debt cycle and the long-term debt cycle lies in whether central banks have the ability to reverse the debt cycle. In the traditional deleveraging process of the short-term debt cycle, central banks will lower interest rates and increase credit supply. However, for the long-term debt cycle, the situation can be very tricky because debt growth has become unsustainable. A typical path to address the long-term debt cycle is: healthy private sector -> excessive borrowing in the private sector, unable to repay -> government sector provides assistance, excessive borrowing -> central bank prints money and buys government debt to provide assistance (the central bank is the lender of last resort).

The long-term debt cycle typically lasts about 80 years and is divided into five stages:

1) Sound Money Stage: Initially, interest rates are very low, and the returns from borrowing exceed the cost of capital, leading to debt expansion.

2) Debt Bubble Stage: As debt expands and the economy begins to prosper, prices of certain assets (such as stocks and real estate) start to rise. With rising asset prices and sustained economic prosperity, the private sector becomes more confident in its ability to repay debts and the returns on assets, thus continuing to expand debt.

3) Top Stage: Asset prices have reached bubble levels, yet debt expansion does not stop.

4) Deleveraging Stage: A wave of debt defaults erupts, asset prices plummet, total demand shrinks, leading to a debt-deflation cycle (Fisher effect), nominal interest rates drop to zero, and real interest rates rise due to deflation, increasing repayment pressure.

5) Debt Crisis Stage: Due to the bursting of asset bubbles, debt bubbles also burst. In this situation, those who borrowed to purchase assets may be unable to repay their debts, and the entire economy faces bankruptcy and debt restructuring. This stage also marks the fading of the long-term debt crisis, reaching a new equilibrium, and a new cycle begins.

In each of these five stages, the central bank must adopt different monetary policies to ensure the stability of debt and the economy. Therefore, we can also observe the current stage of the long-term debt cycle through monetary policy.

Currently, since 1945, the U.S. has experienced 12.5 short-term debt cycles. This year, U.S. debt interest payments are expected to exceed $1 trillion, while total government revenue is only $5 trillion. In other words, for every $4 the U.S. government collects, it has to spend $1 on debt interest!

If this trend continues, the U.S. government will find it increasingly difficult to repay its debts and will ultimately be forced to monetize its debt (print money to repay debts), which will further drive up inflation and cause severe currency depreciation. Therefore, the U.S. is currently in the latter half of the long-term debt cycle, on the edge of Stage 3, the "Top Stage," which indicates that a debt crisis may be imminent.

Next, let's review the first long-term debt cycle experienced by the U.S. from 1981 to 2000, specifically divided into several short cycles.

First Short Cycle (1981~1989): The second oil crisis that erupted in 1979 led the U.S. into the "Stagflation 2.0" era. From February to April 1980, the U.S. bank prime lending rate was raised 9 times consecutively from 15.25% to 20.0%. Inflation rates were at historical highs, and interest rates were also at historical peaks. To avoid systemic risks, monetary policy shifted from tight to loose. From May to July 1980, the Federal Reserve cut interest rates three times, each time by 100 basis points, lowering the rate from 13.0% to 10.0%, totaling a 300 basis point cut. After Reagan took office in 1981, defense spending was significantly increased, and during this period, the government's leverage ratio surged, with outstanding debt rapidly expanding, reaching the peak of this long-term debt cycle in 1984, with a deficit ratio as high as 5.7%. In May, the Illinois Continental Bank, one of the top ten banks in the U.S., experienced a "run," and on May 17, the bank received temporary financial assistance from the FDIC, marking the most significant bank failure resolution in FDIC history. In June, the bank's prime lending rate continued to rise until the Plaza Accord in 1985, which forced the depreciation of the dollar. After the Plaza Accord was signed, the "Gramm-Rudman-Hollings Act of 1985" was introduced, requiring the federal government to achieve a balanced budget by 1991. On October 28, 1985, Federal Reserve Chairman Volcker stated that the economy needed lower interest rates for support. During this stage, the Federal Reserve gradually lowered interest rates from 11.64% to 5.85% to re-stimulate the economy.

However, in 1987, newly appointed Federal Reserve Chairman Greenspan tightened monetary policy again. The rising cost of financing led to a decrease in the willingness of businesses and households to borrow, and the interest rate hikes became a significant trigger for the "Black Monday" stock market crash, further slowing economic growth. In 1987, Reagan signed the Deficit Reduction Act, and the government's leverage increment began to decline, with leverage ratios across sectors slowing down until the end of 1989, entering a sideways phase for social leverage.

Second Short Cycle (1989~1992): The Gulf War broke out in August 1990, causing international oil prices to surge, and the CPI rose to its highest point since 1983. GDP growth reached negative growth in 1991, and in March 1991, the unemployment rate continued to rise sharply. To reverse the economic stagnation, the Federal Reserve adopted an accommodative monetary policy during this period, lowering the federal funds target rate from a peak of 9.8125% to 3%. The massive fiscal expenditures incurred by the war also caused the government's leverage ratio to surge, leading to an increase in social leverage in 1991. On April 1, 1992, a stock market crash occurred in Japan, with the Nikkei index falling below 17,000 points, a 56% drop from its historical peak of 38,957 points in early 1990. Stock markets in Japan, the UK, France, Germany, and Mexico all experienced a chain decline due to deteriorating economic conditions. To respond to the global economic recession, the Federal Reserve again cut interest rates by 50 basis points on July 2.

Third Short Cycle (1992~2000): The Clinton administration, which came to power in 1992, balanced the fiscal deficit by raising taxes and cutting spending. However, the post-war friendly economic development environment and positive economic expectations enhanced the willingness of households and businesses to borrow, promoting an increase in social leverage. Subsequently, the economy expanded, and inflation began to rise again. The Federal Reserve started a series of interest rate hikes in February 1994, raising rates six times by a total of 3 percentage points to 6%. In December 1994, due to the six consecutive interest rate hikes by the Federal Reserve during the year, short-term interest rates rose significantly more than long-term rates, leading to an inverted yield curve. From early 1994 to mid-September, the U.S. bond market lost $600 billion in value, and the global bond market lost $1.5 trillion for the entire year, marking the famous bond market crash of 1994.

Subsequently, the Asian financial crisis erupted in 1997, and the Russian debt crisis broke out in 1998, directly leading to the sudden collapse of Long-Term Capital Management (LTCM), one of the four major hedge funds in the U.S. On September 23, Merrill Lynch and Morgan Stanley provided funds to acquire and take over LTCM. To prevent fluctuations in the financial market from hindering U.S. economic growth, the Federal Reserve cut interest rates by 50 basis points in the third quarter of 1998. The enthusiasm for the development of internet companies continued to rise, and the leverage increment of the non-government sector continued to increase, with corporate leverage reaching its highest level since 1986, driving up the social leverage increment.

In 2000, the internet bubble burst, and the Nasdaq fell by 80%. After the bursting of the internet bubble, the leverage increment of the non-government sector and GDP growth both significantly declined, and the social leverage increment turned negative, leading to a reduction in leverage levels. Economic recession and declining inflation triggered the next round of credit easing and economic recovery, marking the end of this debt cycle.

After that, in the 2008 financial crisis, the U.S. unemployment rate reached 10%, and global interest rates fell to 0%, making it impossible to stimulate the economy through further rate cuts. The Federal Reserve initiated the largest debt monetization in history by printing money to purchase debt. From 2008 to December 2020, the U.S. began a central bank balance sheet expansion to buy debt, essentially involving money printing, debt monetization, and quantitative easing. Subsequently, in late 2021, tightening began to combat inflation, leading to rising U.S. bond yields and a stronger dollar. In 2021, the Nasdaq index fell by 33% from its peak, while high interest rates also resulted in losses for the Federal Reserve.

Having briefly reviewed a debt cycle, as mentioned earlier, the U.S. is on the verge of entering the Top Stage. The transmission path of the long-term debt cycle is from the private sector to the government to the Federal Reserve. So, what will happen when the long-term debt cycle reaches the central bank?

Step 1: The Federal Reserve Expands the Balance Sheet to Monetize Debt

When a debt crisis occurs and interest rates cannot be lowered (for example, to 0%), money will be printed and bonds purchased. This process began in 2008, known as quantitative easing (QE). The U.S. has conducted four rounds of QE, buying a large amount of U.S. Treasury bonds and MBS. The characteristic of QE is that the assets purchased have relatively long durations, which forcibly suppresses Treasury yields, directing money towards risk assets and pushing up their prices.

The money for QE is realized through reserves (the money commercial banks hold at the Federal Reserve). When the Federal Reserve buys bonds from banks, it does not need to spend money; instead, it tells the banks that their reserves have increased.

Step 2: When Interest Rates Rise, the Central Bank Faces Losses

The Federal Reserve primarily earns interest income and incurs interest expenses. The structure of its balance sheet involves borrowing short and buying long, needing to pay interest on short-duration assets like RRP and reserves while earning interest on relatively long-duration assets like Treasury bonds and MBS. However, since interest rate hikes began in 2022, the yield curve has inverted, leading to losses for the Federal Reserve. In 2023, the Federal Reserve reported a loss of $114 billion, and in 2024, a loss of $82 billion.

When the Federal Reserve was profitable, it would remit profits to the Treasury. However, during losses, this portion becomes deferred assets (Earnings remittances due to the U.S. Treasury), which have accumulated to over $22 billion.

Step 3: When the Central Bank's Net Assets Turn Significantly Negative, Entering a Death Spiral

If the Federal Reserve continues to incur losses, it will eventually lead to significantly negative net assets, which is a true danger signal. This marks the onset of a death spiral, where rising interest rates cause creditors to see problems and sell off debt, leading to further increases in interest rates, which in turn leads to further selling of debt and currency. The final result is currency depreciation, triggering stagflation or recession.

At this step, the Federal Reserve faces the dilemma of needing to maintain an accommodative policy to support a weak economy and a financially strained government while also needing to tighten policy (high interest rates) to prevent market sell-offs of currency.

Step 4: Deleveraging, Debt Restructuring, and Depreciation

When the debt burden becomes too heavy, large-scale restructuring and/or depreciation will occur, significantly reducing the scale and value of debt. At the same time, currency depreciation will lead to severe losses in the real purchasing power of currency and debt holders until a new monetary system with sufficient credibility is established to attract investors and savers to hold that currency again. During this stage, governments typically implement extraordinary policies such as extreme taxation and capital controls.

Step 5: Return to Balance and Establishment of a New Cycle

When debt is depreciated and the cycle comes to an end, the Federal Reserve may link the currency to hard currencies (such as gold) and strictly enforce the transition from rapidly depreciating currency to relatively stable currency under conditions of very tight monetary policy and very high real interest rates, thus establishing a new cyclical system.

Through the above steps, it can be basically judged that the U.S. is currently in the transition from Step 2 (central bank losses) to Step 3 (central bank net assets significantly negative, entering a death spiral). What will be the Federal Reserve's next response?

Typically, there are two paths to control debt. One is financial repression, which essentially means lowering interest costs, and the other option is to control fiscal policy, which means reducing non-interest deficits. Lowering interest costs means cutting rates to alleviate interest payment pressure, while reducing non-interest deficits can be achieved through either cutting spending or increasing taxes. The Trump administration has actively promoted both of these, with the DOGE government efficiency department reducing government fiscal expenditures and tariff policies increasing government revenue.

Although Trump has already started vigorously, the global financial market does not seem to be convinced. Major central banks around the world have already begun to continuously buy gold. Currently, gold is second only to the U.S. dollar and the euro, surpassing the yen, becoming the third-largest reserve currency globally.

Currently, the U.S. fiscal situation has a serious problem—borrowing new debt to pay off old debt, filling fiscal gaps through bond issuance, and these new debts bring higher interest expenses, thus trapping the U.S. in a "vicious cycle of debt," potentially leading to a situation where it can "never repay."

In this case, the predicament of U.S. debt cannot be resolved in the short term, and ultimately, it will still have to be addressed according to the two paths of the debt crisis mentioned above. Therefore, the Federal Reserve will choose to lower interest costs to alleviate interest payment pressure. Although cutting rates cannot fundamentally solve the debt problem, it can indeed temporarily relieve some of the interest payment pressure, giving the government more time to cope with the enormous debt burden.

The act of cutting rates actually aligns closely with Trump's "America First" policy. The market currently believes that the tariffs and fiscal policies implemented after Trump took office will cause the U.S. deficit to run out of control like a "wild horse," leading to a decline in U.S. credit, rising inflation, and increasing interest rates. In reality, the rise of the dollar is due to other countries' market interest rates declining significantly compared to U.S. market interest rates (currencies of countries with relatively high interest rates appreciate), and the decline in U.S. bond prices (i.e., rising yields) is also a normal phenomenon of a short-term rebound within a declining interest rate cycle.

As for the market's expectations of re-inflation, unless Trump triggers a fourth oil crisis, there is no logical explanation for why he would want to push inflation levels that Americans detest once again.

As for why rate cuts have been difficult to implement, the expectations for rate cuts have been constantly wavering this year. I believe it is to avoid overextending the expectations for rate cuts; currently, being "hawkish" can provide space for future "dovish" actions.

Looking back at historical experiences since 1990, the Federal Reserve has paused rate cuts in August 1989 and August 1995 to assess subsequent growth conditions and determine the pace and intensity of rate cuts. For example, after the "preemptive" rate cut in July 1995, the Federal Reserve held steady in three consecutive meetings until the U.S. government failed to reach an agreement on the new fiscal year budget and shut down twice, at which point it decided to cut rates again by 25 basis points in December 1995.

Therefore, one should not follow market thinking for reasoning, as it often leads to problems; instead, one should "think and act in reverse." What are the subsequent opportunities?

1. From the perspective of dollar assets, gold remains a relatively good asset; U.S. Treasuries, especially long-term bonds, are poor assets.

2. At some point, the U.S. will either actively or passively begin to cut rates. We should prepare for this and closely monitor the yield on 10-year U.S. Treasuries.

3. Bitcoin remains a quality investment target among risk assets, and its value remains resilient.

4. If U.S. stocks experience a significant correction, consider buying in batches at lower prices; technology stocks still offer high returns.