Why the U.S Debt Matters When it Comes to Investing

 

The federal government’s total debt now stands at more than $36 trillion, roughly double from a decade ago. While some of this debt expansion is due to the pandemic, much of it stems from the aging U.S. population and a dramatic increase in the number of people qualifying for government-sponsored healthcare.

 

Because of the rising debt burden and tighter monetary policy, the interest cost to service the debt ballooned to $882 billion in the 2024 fiscal year. That figure is up 86% from 2022’s figure of $475 billion. While the amount of debt the U.S. should maintain has been debated for years, the sheer volume of debt and the diverting tax revenue to pay interest leaves less money available for other programs. Additionally, as the government issues more debt, it crowds out available resources for private capital.

 

For example, as the level of debt rises, lenders (in this case Treasury bond holders) may require a higher rate of interest to loan money. Consequently, companies looking to issue corporate bonds to fund operation or research and development could also be forced to offer higher rates to attract investors.

How did we get here?

The U.S. Government has run deficits on and off (mostly on) for decades. One of the few exceptions was during the Clinton Administration because of solid tax receipts, higher tax rates, and controlled spending, including somewhat of a “peace dividend” after the Cold War defense spending. However, the annual deficit and total debt took off during the Great Financial Crisis. The Federal Government poured vast sums of money into the U.S. economy to stave off a total meltdown. Entitlement spending and tax revenues have been at a structural imbalance for years, with few signs of change as more Baby Boomers retire each year and qualify for social security benefits.

 

Also, the U.S. has issued more debt, creating a snowball-like effect where more deficit spending is needed to cover outlays and rising interest costs. The U.S.’s political leaders have been spending more recently, while tax cuts have contributed to the problem in recent years. Traditional buyers like the Fed, Japan, and China are buying less U.S. debt, pushing interest rates higher and increasing the cost of the government's borrowing.

 

Recently, the market has often had difficulty digesting new government debt issuance. Several Treasury auctions have been met with soft demand or investor hesitancy, often awarding moderate to large tails that push up U.S. Treasury yields. Higher tails at auctions indicate bond issuers had to entice investors with extra yield over the prevailing market yield of a similar bond. For example, the Three-Year U.S. Treasury note auction in early January was met with pushback from investors, ultimately causing the auction to tail by over one basis point.

 

The market is not the only one hesitant about rising fiscal deficits. In August 2023, Fitch Ratings downgraded U.S. debt from its triple-A credit rating.

 

“In Fitch's view, there has been a steady deterioration in governance standards over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025,” the rating agency said in its release. “The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” In November 2023, Moody’s followed suit by downgrading its outlook on U.S. debt, citing political polarization and the rapidly increasing cost of financing it.

 

The country’s debt ceiling suspension expired at the end of 2024. Early this year, Congress (including some GOP members) refused to give in to Trump’s demands of raising or eliminating the debt limit before he takes office. Despite this, the Treasury Department will continue to issue new debt at least over the next few months as “extraordinary measures,” such as using cash on hand to make required principal and interest payments, are implemented. Analysts estimate that these measures may allow Congress to avoid coming to a longer-term solution until later in the year.

 

For the Federal Government’s most recently completed fiscal year:

 

The largest receipts for 2024 include:

• Individual Income Taxes: $2.4 trillion (49% of total receipts)
• Social Insurance and Retirement: $1.7 trillion (35% of total receipts)
• Corporate Income Taxes: $530 billion (11% of total receipts)

 

The remaining revenue streams account for just $253 billion (5% of total receipts).

 

The largest expenses for 2024 include: 

• Health/Human Services and Medicare: $1.8 trillion (26% of total outlays)
• Social Security Administration: $1.5 trillion (22% of total outlays)
• Net interest: $882 billion (13% of total outlays)
• Dept. of Defense: $874 billion (also 13% of total outlays)

 

The largest expenses are primarily considered government obligations (non-discretionary spending) and cannot be reduced quickly or without serious future reforms. The nation spent more on interest payments than it did on the Department of Defense. It would be difficult to cut defense spending given the geopolitical tensions around the globe, as well as the military bases and military contractors across the country.

 

The government’s net interest expense totaled $882 billion. It is possible that interest expense could top $1 trillion in the coming years.

 

The Congressional Budget Office recently announced that it expects fiscal year 2025’s budget deficit to reach $1.94 trillion—up from $1.83 trillion last year.

Impact on the U.S. economy.

The amount of government debt and interest on the debt has so far had a relatively small impact on the U.S. economy, which has surprised some economists. Many market participants had expected a shallow recession, which would blunt some of the criticism of runaway deficit spending. However, the economy has held up surprisingly well. One contributing factor is the relatively low level of debt held by consumers. Recent estimates suggest roughly 60% of home mortgage holders have rates at 4% or lower, which has damped the effect of higher interest rates elsewhere in the economy.

 

That doesn’t mean the debt and deficit spending won’t harm economic growth in the future. As stated earlier, larger deficits imply less financial flexibility.

 

Countries often accrue additional debt to keep various programs functioning during economic downturns. In our case, the U.S. economy has been expanding, making the spending and interest costs even more precarious. However, when the U.S. economy eventually contracts (a safe assumption), the debt could look even worse since tax receipts fall during soft economic activity.

Impact on investing.

While the U.S. economy has surprised to the upside, there are cautionary notes with all the debt. Many of the issues appear in the fixed-income universe and include:

• The more debt an entity has, the higher the likelihood it will be unable to repay it. There is an increased default risk, and investors will demand higher yields if there is a greater risk of default. This is why rating agencies have downgraded U.S. debt. However, this is still an incredibly minor risk associated with U.S. Treasury obligations.
• When an entity issues more debt, there needs to be buyers and holders of that debt to match the increased supply. To match supply, the price must go down (or fixed-income yields must go up). This is another supply/demand characteristic.
• Higher yields can be a vicious cycle. One option is to issue more debt to pay the higher interest on previously spent money.

 

Within equities, some of the impacts are related to fixed income and include:

• Increased debt issuance can push up Treasury yields, making them more attractive than equities. However, this has yet to take place on a large scale as investors generally remain positive on equities, given the strength of the U.S. economy, and wary of still-rising fixed income yields.
• Debt often means that the U.S. Government is spending money in certain areas, which can impact equity sectors positively or negatively.
• Debt also often means reduced revenue through tax cuts. Companies and equities enjoy paying fewer taxes since they can affect the bottom line.

 

Within the alternative investment universe, most private debt for example, comes with a floating rate. Borrowers in the private debt space may pay higher interest rates as more government debt is issued, pressuring their cash flows, profit margins, and expansion plans.

Why it matters.

The nation’s interest expense and deficit spending could harm the nation’s status as the world’s reserve currency.

 

In short, countries hold U.S. currency for transactions with other countries because they see the U.S. dollar as stable and safe. When foreign countries conduct transactions with one another, they typically do so with the U.S. dollar. Many foreign currencies are also pegged to the dollar, one of the nation’s strengths.

 

If the U.S. were to lose its status as the world’s reserve currency, it would likely have less access to capital and incur higher borrowing costs. This could adversely impact stock market valuations as well.  America’s status as a reserve currency has allowed the nation to, in part, run deficits. If foreign countries no longer want to hold the dollar, it could force some unpleasant belt-tightening. The counterargument is that even though the U.S.’s trajectory is troubling, no clear rival exists. However, with digital currencies, strong foreign competition, and domestic discord, another currency may become more attractive.

 

Also, the debt will restrict growth. A recent CBO projection shows the weight of the debt will slow income growth by 12% over the next 30 years since debt payments will crowd out other investment opportunities.

 

If there is a positive aspect, the U.S. is the most resourceful, innovative, and economically successful country in history. The country’s ingenuity and determination are incredibly valuable traits. Righting the ship will take the brightest minds and the most determined people available, and the U.S. has those people. Also, some leaders in the U.S. historically wait until the last minute to address and deal with a problem. We are not at that point yet, but it is undoubtedly getting closer, and leaders in Washington, D.C need to address the issue.

 

This report was researched and written by 1834’s Joe Styrna, senior portfolio manager and senior vice president, Patrick Rehkamp, senior financial writer and Jakob Hebebrand, fixed income analyst.