U.S. National Debt: The Bond Market Doesn’t Care

For almost my entire 38 year career in Finance, we’ve worried about the U.S. Federal deficit. Someone recently asked me if we should still be worried. You’d think that it should have been a problem by now, but it’s not. Thirty year treasury bonds yielding 3% don’t look enticing, but evidently, a lot of investors feel differently. Low as they are, U.S. yields are substantially higher than Germany, whose 30-year bonds yield a paltry 0.73%.

Federal Debt as a Percentage of GDP

U.S. publicly-held Federal debt to GDP rose sharply following the 2008 financial crisis. Circumstances justified a temporary spike to provide fiscal stimulus, but instead, it’s continued to grow. Nonetheless, rates just can’t rise — even though the Fed has stopped buying bonds, others have stepped in. Short term rates might even have peaked, following Fed chairman Jay Powell’s communication missteps in December.

The deficit doesn’t seem to matter. As President Reagan joked, “I am not worried about the deficit. It is big enough to take care of itself.”

This view is easily criticized as needlessly reckless with our country’s future. Markets are forward-looking, and most observers are pessimistic about our long-term fiscal outlook. But yields don’t reflect that. Since our current indebtedness is clearly manageable, it’s worth considering alternative outcomes.

Excessive debt was part of the reason for the 2008 crash. As the economy recovered, the U.S. pursued a stealth devaluation by maintaining negative real interest rates. It’s a well-worn path, and while Ben Bernanke didn’t articulate it as such, treasury yields were so low that buyers suffered a loss of purchasing power after taxes and inflation. Even today there’s hardly any return, although a large proportion of the holders aren’t taxable.

Populism adds an interesting dimension. Let’s suppose that U.S. bond yields rise to more fully reflect the sorry state of fiscal policy. Increased interest expense crowds out other expenditure. The Congressional Budget Office forecasts that net interest expense will double by 2024 and almost triple by 2029. They assume ten-year yields rise to around 3.7%. The U.S. Debt Clock has some interesting figures.

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