Over the past few decades, concerns about fiscal sustainability in the U.S. have come and gone in waves. Usually, interest moves to the next topic quickly enough to avoid lasting damage and therefore serious talks of remedies and/or consequences. Yet, it is becoming increasingly difficult to ignore that beneath the surface of resilient consumer and economic data and equity markets churning near historical highs, the U.S. is running deficits that outpace our economic output at a pace not seen since World War II.
There are multiple elements that have contributed to our $1.7 trillion budget deficit. The mandatory spending in programs like Social Security, Medicare, and Medicaid make up over half of the budget. Defense spending remains a major component of the federal budget as well. Even outside of direct military engagement, defense spending has not offered relief for the budget. Lastly, revenue has not kept up with spending as growth in the tax base has stagnated relative to expenditures.
However, the obvious accelerant of the deficit is debt service, or the interest payments on the federal debt. The higher the interest rate goes on Treasurys, and the higher the debt level, the higher the cost to the federal government. The interest rate on Treasurys is like the price the market is charging to hold the debt. If the market views the debt as more risky, it will charge more and that will be reflected through a higher interest rate. If the logic feels circular, that’s because it is. The debt going higher makes U.S. bonds less desirable meaning that the interest rate will face upward pressure which forces federal debt servicing costs higher which forces the U.S. to borrow more to finance the higher spending and on and on and on. This phenomenon can potentially fall into a negative feedback loop. In other words, the debt feeds on itself.
We saw this come together in a sense last week when the fiscal package debate was at a fevered pitch. A $16 billion auction of 20-year Treasury bonds met less enthusiasm than anticipated and sold at a higher yield. The softer demand for the bonds sparked fears of waning appetite for the bonds, which pushed Treasury rates higher, and weighed on equities and the dollar.
In our opinion, this is the driver of risk across the global investment landscape in the long-term, and possibly in the near term, as focus has shifted somewhat from tariffs to the budget and impact on debt and deficits. The anchor of the pricing of investment risk is the risk-free rate, almost always assumed to be the long-term Treasury rate. If the basis of the pricing of risk is perceived to be in jeopardy in any form or fashion, the impact will reverberate well beyond the U.S. and even beyond the realm of investment management.
By J. Keith Buchanan, CFA, Senior Portfolio Manager
Originally published June 4, 2025
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