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,1 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).2

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%.