The big US fiscal deficit and effect on market rates

The US fiscal deficit in cash terms has hit US$2tr – a substantial number, equating to some 7.5% of GDP. Some unusual factors caused a shortfall on the revenue side, but there is a structural excess of government spending over receipts in the area of 6% of GDP. The baseline expectation is we are stuck with this in the coming years, at least until we see a policy overhaul. These are scary numbers that mean one key thing for bond markets – sustained supply pressure.

The question then is what this means for rates. It’s difficult to be precise on these things, but an elevated fiscal deficit should place upward pressure on rates, despite Treasury Secretary Janet Yellen’s recent assertion to the contrary. The key question centres on the size of this effect. The often-quoted Harvard/Bank of England 2019 study suggests that every 100bp increase in the budget deficit as a percentage of GDP adds 35bp to market rates.

We’d overlay this by asserting that the average US fiscal deficit has tended to be in the 3% area. The current 6% deficit is 300bp above that. If the study is correct, this should add 100bp to market rates. We’d also assert that the bulk of this should be impacting the shape of the curve, so for any given funds rate we should expect to see a steeper curve (all other things being equal). And the bulk of this could come from higher real rates.

Debt dynamics are also key here. There are a few items to consider:

First, we have interest payments. These are projected at US$745bn for 2023, equating to 2.7% of GDP. That’s up from 1.9% of GDP for 2022, and is projected to extend to 3.7% of GDP over time as bonds get rolled over. Absolute interest payments are projected to hit US$1tr by 2028. And interest payments as a proportion of the fiscal deficit will rise from 35% today to 60% by 2029, on unchanged policies. This data comes from the Congressional Budget Office and extends through ING estimates.

Second, we have debt dynamics. The US currently has a primary deficit of 3.3% of GDP (the rest of the fiscal deficit is interest payments). And the primary deficit remains in the 3% to 3.5% range in the coming years. This pushes up overall debt at this pace every year unless real GDP growth exceeds the average real coupon print by a greater amount. The current average real coupon print is around 1%, but this will head to 2% if we assume that something like the current curve remains in place. The US would have to grow by 5-6% per annum to offset the primary deficit. Based on that, the trajectory for the debt/GDP ratio sees it heading to 200% of GDP (currently around 100% of GDP) in the coming two decades.

The same Harvard/Bank of England 2019 study suggests that every 10 percentage point rise in the debt/GDP ratio also adds 35bp to market rates. Based on the current trajectory, we’ll have a 10ppt increase in the US debt-to-GDP ratio by 2027. This is less impactful, as it’s a slow grind effect. But the cumulative effect is still significant and places an underlying steepening effect on the curve. The US Treasury has taken pressure off the back end by morphing issuance towards the front end. But this does not take the weight of the supply issue away.