Debt-to-GDP Ratio and Investment Risk Premiums

Is the government debt-to-Gross Domestic Product (GDP) ratio a useful predictor of stock and bond market returns? In his May 2021 paper entitled “Government Debt and Risk Premia”, Yang Liu examines relationships between future stock and bond market excess returns (relative to short term government bills) and government debt-to-GDP ratio. He measures government debt as market value of the federal government debt held by the public. For the U.S., this means aggregate market value of all Treasury bonds, Treasury notes, Treasury bills, TIPS, etc. across maturities, excluding government accounts and Federal Reserve holdings. Using debt and GDP data for the U.S. during 1926 through the mid-2010s, associated U.S. stock and bond market return data during 1926 through 2020 and comparable data for 19 major developed countries spanning 1970 through 2018, he finds that:

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