U.S. Budget Deficit: Impact on Interest Rates and Insurance Markets

Historical Context of U.S. Budget Deficit

The U.S. budget deficit has reached unprecedented levels, with a debt-to-GDP ratio of 100% and a deficit of 6-7%, the largest in peacetime. Historically, during Volcker's rate hikes, the debt-to-GDP was 35% and the deficit 3%. The COVID-19 pandemic further exacerbated these figures globally.

"The debt to GDP is 100%. The deficit is running at 6% or 7%. It's the largest peacetime deficit we've ever run. Remember, that deficit is large." --- (JPM, Investor Day, 2024/05/20)

"It's not priced anywhere, but exists. The second one is, as this process of shoring the economy from COVID and all the other challenges, we have a massive deficit pretty much in every country and a massive amount of debt to GDP. So how that one is going to play out in a geopolitical well that is very different than what it was is another area that we all have to keep an eye on." --- (JPM, Investor Day, 2024/05/20)

"So when Volcker raised rates on a Sunday night by 200 basis points, the debt to GDP was 35% and the deficit was 3%. Something drove that inflation." --- (JPM, Investor Day, 2024/05/20)

Relationship between U.S. Budget Deficit and Interest Rates

Market expectations for interest rate cuts and the impact of Federal Reserve rate changes on deposit pricing highlight the interconnectedness of interest rates and broader economic factors, including the U.S. budget deficit. Changes in interest rates influence financial institutions' hedges and net interest income, reflecting the broader economic environment.

"Interest rates — Coming into this year, markets anticipated as many as five or six interest rate cuts." --- (WFC, press release, 2024/06/12)

"These hedges have a weighted average life of just over two years. And they've got an average fixed rate of approximately 250 basis points. So starting in the second-half of 2025, we begin to get some additional NII tailwind, because the cash flow hedges with lower fixed rate likes where we receive, those will begin to roll off, and will likely replace those at higher current market rates at the time." --- (BAC, earning call, 2024/Q2)

"with our average deposit cost up 10 basis points in the second quarter after increasing 16 basis points in the first quarter. If the Fed were to start cutting rates later this year, we expect that deposit pricing will begin to decline with the most immediate impact from new promotional rates in our consumer business and standard pricing for commercial deposits where pricing moved faster as rates increased, and we would expect betas to also be higher as rates decline. On Slide 5, we highlight loans and deposits." --- (WFC, earning call, 2024/Q2)

Broader Economic Implications of a Rising Budget Deficit

Rising U.S. budget deficits contribute to economic uncertainty, influencing interest rates, inflation, and capital market volatility. These macroeconomic factors, coupled with global economic and geopolitical conditions, directly and indirectly impact business operations, increasing borrowing costs and complicating financial forecasting.

"Our results are inherently unpredictable and may be materially affected by many factors, including fluctuations in foreign exchange rates, changes in global economic and geopolitical conditions and customer demand and spending, including the impact of recessionary fears, inflation, interest rates, regional labor market constraints, world events, the rate of growth of the Internet, online commerce, cloud services and new and emerging technologies, and the various factors detailed in our filings with the SEC." --- (AMZN, earning call, 2024/Q1)

"In addition, economic conditions and actions by policymaking bodies are contributing to changing interest rates and significant capital market volatility, which, along with any increases in our borrowing levels, could increase our future borrowing costs." --- (AMZN, sec filing, 2024/Q1)

"Overview Macroeconomic factors, including inflation, increased interest rates, significant capital market and supply chain volatility, and global economic and geopolitical developments, have direct and indirect impacts on our results of operations that are difficult to isolate and quantify." --- (AMZN, sec filing, 2024/Q1)

"and productivity. In addition, global economic and geopolitical conditions and additional or unforeseen circumstances, developments, or events may give rise to or amplify many of these risks." --- (AMZN, sec filing, 2024/Q1)

Impact of Interest Rate Changes on Insurance Companies

Rising interest rates benefit insurance companies by increasing investment income and product attractiveness but also pose challenges like higher loss costs and long-duration interest rate risks. Companies like AIG and Prudential manage these impacts through asset/liability management and product portfolio adjustments.

"While the impact of rising interest rates on our General Insurance segment increases the benefit of investment income, the current and medium-term inflationary environment may also translate into higher loss cost trends." --- (AIG, sec filing, 2024/Q1)

"We seek to manage the impact of changes in interest rates on these contracts through asset/liability management, as discussed above." --- (PRU, sec filing, 2024/Q1)

"interest rates continue to increase the attractiveness of many of the products we offer within RIS." --- (MET, earning call, 2024/Q1)

"In response to consumer needs and a changing interest rate environment, our Life Insurance product portfolio will continue to promote products with less long-duration interest rate risk and mitigate exposure to products that have long-duration interest rate risk through sales levels and hedging strategies." --- (AIG, sec filing, 2024/Q1)

"The decrease in general account investments related to our Japanese insurance operations in the first three months of 2024 was primarily due to the translation impact of the U.S. dollar strengthening against the yen and an increase in U.S. interest rates, partially offset by net business inflows and the reinvestment of net investment income." --- (PRU, sec filing, 2024/Q1)

Insurance Companies' Investment Strategies

Insurance companies are employing disciplined pricing, asset-liability management, and strategic portfolio assessments to support their operations and meet policyholder obligations. They are also engaging in significant reinsurance agreements to manage risk and leverage their scale across markets, ensuring capital stewardship and consistent returns.

"For investment-oriented products, including universal life insurance, and variable, fixed and fixed index annuities, in our Individual Retirement, Group Retirement, Life Insurance and Institutional Markets businesses, our spread management strategies include disciplined pricing and product design for new business, modifying or limiting the sale of products that do not achieve targeted spreads, using asset-liability management to match assets to liabilities to the extent practicable, and actively managing crediting rates to help mitigate some of the pressure on investment spreads." --- (AIG, sec filing, 2024/Q1)

"The Company’s investment portfolio is managed to support its insurance operations; accordingly, the portfolio is positioned to meet obligations to policyholders." --- (TRV, sec filing, 2024/Q1)

"Finally, we assess both strategic and operational impacts in order to prioritize and make choices on where to focus our efforts across the total portfolio including overlaying both a global and local market perspective so that we can craft strategies and to address opportunities across the board and leverage our scale across channels. And while we invest at" --- (ALL, event transcript, 2024/06/25)

"To close, we recognize that capital is precious and we never take for granted the trust you place in us to be good stewards of your capital.The next evolution of our strategy will build on the strong foundation we have created and deliver growth, returns and consistency for shareholders and other stakeholders." --- (MET, AGM, 2024/06/18)

"Retirement Strategies Business Updates • In May 2023, the Company entered into an agreement with The Ohio National Life Insurance Company, now known as AuguStar Life Insurance Company (“AuguStar”), an affiliate of Constellation Insurance Holdings, Inc., to reinsure approximately $10 billion of account values of PDI traditional variable annuity contracts with guaranteed living benefits issued by Pruco Life Insurance Company, a wholly-owned subsidiary of Prudential Financial." --- (PRU, sec filing, 2024/Q1)

Impact on Insurance Policy Pricing and Cost Structure

Strategic decisions, market conditions, and economic factors are significantly impacting insurance policy pricing and cost structures. Companies like Allstate and Travelers are adjusting premiums and coverage offerings, while Prudential and MetLife are navigating market value changes and risk-bearing investments. High net worth policies face unique pricing challenges, as highlighted by AIG.

"Commercial lines premiums written decreased 30.8% or $70 million in the first quarter of 2024 compared to the first quarter of 2023 due to profitability actions taken to no longer offer coverage to transportation network companies unless the contracts utilize telematics-based pricing and the Allstate brand exiting traditional commercial insurance in five states, which will continue to negatively impact premiums." --- (ALL, sec filing, 2024/Q1)

"Long-Term Care Results increased $39 million compared to the prior year period primarily reflecting favorable impacts from changes in the market value of equity securities and higher underwriting results driven by net favorable policyholder experience, partially offset by more unfavorable impacts from changes in the market value of derivatives used for duration management and lower income on non-coupon investments." --- (PRU, sec filing, 2024/Q1)

"These factors may persist for some time and may continue to impact pricing levels of risk-bearing investments, as well as our business operations, investment portfolio and derivatives." --- (MET, sec filing, 2024/Q1)

"And then you have the freedom of limit. So like if you do high net worth business, which we're in, on an admitted basis and you have replacement cost, it's got a lot of risk in terms of understanding what the total cost of a cat would be because replacement cost, replacement cost and you can't really do a whole lot in terms of changing the policy limits or how you actually structure that." --- (AIG, conference, 2024/05/29)

"Net written premiums from both renewal and new business, and therefore earned premiums, are impacted by competitive market conditions as well as general economic conditions, which, particularly in the case of Business Insurance, affect audit premium adjustments, policy endorsements and mid-term cancellations." --- (TRV, sec filing, 2024/Q2)

Regulatory and Policy Responses

Financial institutions are heavily influenced by regulatory and policy responses to the U.S. budget deficit. Banks like Bank of America, Wells Fargo, Goldman Sachs, Citigroup, and JPMorgan Chase emphasize the importance of regulatory compliance and the potential impacts of increased oversight and capital requirements on their operations and market activities.

"We commend the bank for setting these goals, but their success may depend on policy and regulatory response to the transition." --- (BAC, event transcript, 2024/04/24)

"While we see clear forward momentum, it's up to our regulators to make their own judgments and decide when the work is done to their satisfaction. Progress has not been easy, but tens of thousands of my partners at Wells Fargo have now worked tirelessly for years to deliver the kind of change necessary for a company of our size and complexity, and we will not rest until we satisfy the expectations of our regulators and the high standards we have set for ourselves. While we have made substantial changes and have meaningfully improved our control environment, the industry operates in a heightened regulatory oversight environment, and we remain at risk of further regulatory actions." --- (WFC, earning call, 2024/Q2)

"If uncertainty and concerns about geopolitical tensions and the economic outlook remain elevated or grow, including those about central bank policy, inflation, the commercial real estate sector, and potential increases in regulatory capital requirements, it may lead to a decline in asset prices, a decline in market-making activity levels, or a decline in investment banking activity levels, and net revenues and provision for credit losses would likely be negatively impacted." --- (GS, sec filing, 2024/Q1)

"and the data related to regulatory reporting. We're committed to getting these right and we'll look to self-fund the necessary investments to do so." --- (C, earning call, 2024/Q1)

"While we remain confident in our ability to produce strong returns and manage risk across a range of scenarios, the economic, geopolitical, and regulatory uncertainties that we have been talking about for some time remain prominent, and we are focused on being prepared to navigate those challenges, as well as any others that may come our way. And with that, let's open up the line for Q&A." --- (JPM, earning call, 2024/Q1)

Impact on Consumer Behavior and Spending

High interest rates and inflation are shifting consumer spending from goods to services, pressuring discretionary categories like home improvement and hardlines. Retailers are balancing price and value to attract both budget-conscious and higher-income consumers amid an uncertain economic environment.

"The decrease in comparable customer transactions reflects the impact of macroeconomic factors, including the continued shift in consumer consumption trends away from goods and towards services and the impact of a high interest rate environment, pressuring home improvement demand." --- (HD, sec filing, 2024/Q1)

"This normalization, combined with the cumulative impact of higher prices on consumer budgets, is resulting in continued soft trends in discretionary categories, most notably in Home and Hardlines." --- (TGT, earning call, 2025/Q1)

"So I guess the question is and this is happening at a time when other retailers are maybe doubling down on opening price point and are not seeing a stable consumer. So I guess my question is, how do you maintain the balance of being known for price and value and convenience too, but also welcoming these higher income consumers? And is that a delicate balance that you think about?" --- (WMT, event transcript, 2024/06/07)

"During 2022, we faced a number of challenges. We saw prominent macroeconomic headwinds as the world adjusted to life post COVID, including the highest levels of inflation we've seen in Amazon's history and an overall uncertain consumer environment." --- (AMZN, event transcript, 2024/05/22)

"And you mentioned the lockup effect, just simply don't know. Is it a factor of folks waiting for rates to decline or is there a mindset shift that becomes accustomed to a higher rate environment and says this is normal, I have to upsize, I have to improve in place." --- (HD, conference, 2024/04/04)

Future Outlook of U.S. Budget Deficit and Its Impact

The future outlook of the U.S. budget deficit suggests a more complicated environment, influenced by higher labor costs, inflation, and interest rates. These factors, coupled with geopolitical and market uncertainties, are expected to impact interest rates and insurance markets significantly.

"Now let's turn towards the future. As we look forward and as we've been saying for a couple of quarters now, the environment is getting more complicated." --- (JPM, Investor Day, 2024/05/20)

"Of our non investment grade exposure, 70% is secure. In the past year, we've clearly seen the impact of higher labor costs, baseline inflation, interest rates along with elevated geopolitical and market uncertainty and through all of this, any stressful losses that we have seen to date have been idiosyncratic or concentrated in sectors that we've been watching closely." --- (JPM, Investor Day, 2024/05/20)