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Economic and Market Commentary

Bond Markets Overlook U.S. Debt Trajectory, For Now

Debt levels will likely continue to rise absent policy changes, and the yield curve is likely to steepen.

With bond yields declining in recent months, it would appear that mounting U.S. federal debt isn’t at the forefront of investors’ minds. Yet many clients have asked about the sustainability of the path of U.S. debt, whether politicians plan to do anything about it, and whether the “bond vigilantes” will ultimately emerge to push borrowing costs higher.

While some of the drivers of the 2023 deficit surge will recede, they will likely be replaced in the longer term with ever-larger and more persistent drivers, particularly the growing share of Medicare and Social Security spending. Absent changes to either mandatory spending or taxes, which we do not see as likely over the next several years, we believe that the market will eventually demand – and earn – a premium for holding longer-dated Treasuries, and that this will lead to a steeper U.S. yield curve over time.

To be clear, although the long-term debt trajectory is problematic, we don’t believe there will be a fiscal crisis in the U.S. anytime soon, and we continue to believe U.S. Treasury bonds represent an important component of an asset allocation strategy.

2023 saw a deficit “perfect storm”

Last year, the U.S. budget deficit reached nearly $2 trillion, or 7.5% of GDP – more than double its 50-year average of 3.7% – with revenues falling by 9% at the same time spending increased by 11%, according to the nonpartisan Congressional Budget Office (CBO).

To be sure, some of the deficit increase was driven by temporary, one-off factors, such as a greater usage of expiring COVID-era tax credits, the Federal Deposit Insurance Corporation’s support of Silicon Valley Bank, and a one-time cost-of-living-adjustment of Social Security benefits.

Nevertheless, one of the biggest drivers – amounting to more than $700 billion, nearly as much as the Pentagon’s budget – was the cost of servicing the U.S. debt. As a percentage of GDP, interest expense reached 2.9% of outlays in 2023 versus the 50-year average of 1.9%.

Troubling trajectory

Longer term, the CBO expects the outstanding federal debt to grow to 172% of GDP by 2054, from 98% in 2023, while interest expense could be as high as 6.5% of GDP. Of course, these figures are predicated on assumptions that may not materialize, but the direction of travel is clear and disconcerting, absent policy changes.

More alarmingly, the CBO projects Medicare, Social Security, and other healthcare obligations to grow to more than two-thirds of all noninterest spending by 2053, from around half today, as the U.S. population ages. While the 2022 Inflation Reduction Act made incremental changes to the cost of pharmaceutical drugs for Medicare, the cost curve for other areas of Medicare will continue to slope upward absent policy changes.

Will politicians do anything about it?

To some extent, the politics of austerity have returned to Capitol Hill, evidenced by the recent fiscal fights over government funding and the debt ceiling. Ironically, however, those fights have been over a relatively small part of the government pie – discretionary spending – which Congress authorizes every year to fund everything from the Pentagon to national parks to cancer research. While essential, this spending amounts to a little more than a quarter of the government’s $6.4 trillion budget, or $1.7 trillion, and is expected to decline as a percentage of GDP in the long run.

At the same time, both parties’ presumptive presidential nominees have vowed to not touch either Medicare or Social Security, even for future beneficiaries. Both have indicated they are likely to extend – at least to some extent – the expiring tax provisions under the 2017 Tax Cuts and Jobs Act at the end of 2025. Depending on the details, that could add about another $3 trillion or $4 trillion to the U.S. debt over 10 years.

Given what both presidential nominees have indicated, meaningful changes on either the revenue or spending side of the equation are unlikely until at least 2029.

Implications for markets

At our latest secular forum in May 2023, we concluded that “with rising government debt ... we expect the yield curve to steepen as investors demand more compensation on longer-term bonds” over the coming years (for more, see our Secular Outlook, “The Aftershock Economy”).

At the same time, as we concluded at our secular forum, the U.S. dollar will likely retain its status as the dominant global currency, despite a widening U.S. fiscal gap and growing indebtedness. So we believe there will be some limit to how high yields go, as long as the U.S. dollar and U.S. Treasuries remain the “cleanest dirty shirt” in the global sovereign bond market closet.



[i] Fiscal year, which ended 30 September 2023. Data is from the Congressional Budget Office if not stated otherwise; excludes effects from cancellation of student deficit for both 2022 and 2023 since the Supreme Court overruled that policy

[ii] https://www.cbo.gov/system/files/2023-11/59640-MBR.pdf

[iii] The 2023 Congressional Budget Office Long-Term Budget Outlook

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Disclosures

A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government.

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