Beauty and the Beast

As President Trump’s ‘Big Beautiful Bill’ passes to the Senate, economists have become more nervous about the size and sustainability of fiscal deficits as a proportion of GDP, particularly in the US, and the possible implications for the US dollar. According to the Congressional Budget Office (CBO), public holdings of US federal debt for FY25 are estimated at £30.1 trillion compared to nominal GDP of £30.1 trillion, meaning that the debt-to-GDP ratio is now 100%. It is worth noting that many other developed economies, such as the UK (96%), Belgium (109%) and France (116%) are also in a similar position

My colleague Rob Murphy compiled this analysis, and tries to explain how we got here. Is this sustainable? Can the situation be improved? What might the consequences be? It is slightly longer than our usual commentary, but well worth the extra time as it’s a timely piece.  

 Taking the US as of yesterday, the 30-year US treasury bond yield was just over 5%, a level similar to that in October 2023, when inflation was around 8%, compared to today’s 2.3%. 

Current long-term bond yields feel high in comparison to the years before COVID. It’s interesting to note that, on a longer-term perspective, 30-year treasury yields of 5% are unremarkable. According to FactSet, the 30-year US treasury bond yield was equal to or exceeded 5% from the mid-80s to the early 2000s, when inflation averaged around 3%, roughly where it is now. This would suggest the bond market is less concerned at present than economists about the level of budget deficits, and has confidence over time that these deficits will be addressed.

To sustain economic growth, governments have continued to borrow more, with large jumps due to the COVID pandemic’s enormous costs and the GFC before that. But even in stable periods, the debt burden has risen steadily. The rapid growth in debt has been astonishing; in 2000, the debt-to-GDP ratio was 34%, and post-GFC in 2010, it was 61%. Pre-COVID in 2019, the ratio had risen to 79%, which jumped to 99% in 2020.  Since 1962, the Federal budget has only been in surplus in five years: 1969, during and just after the financial bubble, 1998-2001. 

CBO data shows that the average total deficit in the US has averaged 6% over the last four fiscal years (2022-2025), and even before Trump’s spending bill, was forecast to average 5.4% in the next three years to 2028, at which point, in theory, debt to GDP rises to 105%. By 2035, debt-to-GDP is projected at 118% and in 2045 at 136%. Post-Trump bill, over $3tn would be added to the 2035 figure, or another 7% of GDP. 

What is sustainable? 

The total annual deficit consists of two components. The primary deficit represents the difference between government revenues and expenditures before accounting for interest costs. The total deficit includes net interest costs. Therefore, as long as the primary deficit plus interest costs is less than or equal to GDP growth, the debt-to-GDP ratio stabilises or declines. Assuming a long-term GDP growth expectation of 4%, the debt-to-GDP ratio would stabilise if the primary deficit were zero and the interest rate were 4%, for instance, and this would hold true regardless of how large the initial debt-to-GDP ratio is. Conversely, a primary deficit of 1% and an interest rate of 3% would yield the same outcome.  

In the USA, the primary deficit is 3.1%. Thus, interest costs already account for 3% of GDP, nearly half the deficit, and are set to rise mechanically as current interest rates average more than this across the yield curve. The CBR projects interest costs will exceed 4% of GDP in 10 years, which intuitively feels uncomfortable. The message is that as the level of debt to GDP rises, interest rates become increasingly crucial. 

Hence, we can say that the limit of sustainability is when the market is no longer willing to finance the debt issuance. At this point, there would likely be some combination of rising interest rates, currency devaluation, and accelerating inflation. 

One can model an economy starting at a 100% debt-to-GDP ratio, growing at 4% nominal per annum, with a 4% interest rate and a 3% annual primary deficit (17% revenues, 20% expenditures). By year 10, the debt-to-GDP ratio is 130%, and interest costs around 5% of GDP. At a 5% interest rate, the debt-to-GDP ratio would be 141%, and interest would cost 6.6% of GDP and equal to 1/3 of primary federal expenditure.  

If one imagines two countries identical in all respects except that one has a much higher and growing debt-to-GDP ratio than the other, then the currency of the former would be weaker and devalue over time. Thus, we doubt the sort of figures modelled above by year 10 would be tolerable for bond investors (or indeed politically, given the absolute size of interest payments) without a significant interest premium. 

Can the beast be tamed? 

It can be easy to become overly pessimistic; however, the dynamic and innovative US economy has historically endured many challenges. 

Remember that debt to GDP stabilises if the budget is balanced and interest rates do not exceed GDP growth. The Federal government could cut spending and raise taxes by approximately 15% each, thereby balancing the primary deficit. This would likely lead to a recession and pose challenges for the stock market, but the stock and bond markets would eventually adjust to the resultant debt-to-GDP stabilisation, even if at a structurally higher debt-to-GDP ratio. However, we are uncertain whether the US is politically prepared for such extensive measures, as much of the expenditure increase in recent years has been driven by ‘mandatory’ spending (Social Security, Medicare, Medicaid) due to an ageing population rather than ‘discretionary’ spending (defence, etc). Trump is reducing some mandatory expenditure items while extending tax breaks. 

Another course of action could involve central bank yield curve control or the monetisation of debt through quantitative easing, aiming to suppress interest rates artificially. However, this could lead to inflation and/or currency devaluation, which policymakers might consider an acceptable cost. In this scenario, stocks would be much more preferred to bonds. 

A more positive path to stabilising the deficit is if the dynamic US economy outperforms significantly. Perhaps AI or other tech innovations, such as chip manufacturing, could boost productivity dramatically and lead to far stronger GDP growth in the medium to long term. 

Conclusion 

The scale and outlook for US deficits in the next few years mean that the debt sustainability issue may not go away in the short term, but a disaster also does not appear imminent. Demographics will create structural pressure on government budgets. The paths to debt sustainability generally involve some pain through more government deficit reduction plans, weaker currencies, and/or inflation. This would suggest the outlook for long-term bonds certainly looks less favourable than for equities. 

Dynamic and innovative economies should be able to manage better through superior productivity and growth. Thus, the US equity market will remain an attractive source of investment ideas over the long term.