U.S. Federal Deficits: A Familiar Problem with Potentially Far-Reaching Consequences
Introduction
U.S. federal deficits, which occur when government expenditures exceed tax revenues, have been a persistent feature of the national landscape. Debt and deficits have risen dramatically in recent decades, particularly during the 2008 financial crisis and again during and after the COVID-19 pandemic in the years 2020-2023. In 2024, the U.S. budget deficit stands at a substantial $1.8 trillion, driven largely by increases in Social Security, Medicare, Defense spending, and—let’s not forget—interest payments on our national debt, which now exceeds a staggering $35 trillion. This situation has naturally sparked concerns about the long-term sustainability of such debt levels.
As deficits grow, the government is left with little choice but to issue more debt in the form of Treasury bonds. This year, about one-third of our total debt needs to be rolled over, requiring us to return to the bond market and pay whatever interest rates are offered. This continuous cycle of borrowing and issuing debt can have widespread impact on markets. Let’s explore these consequences in more detail.
A chart showing the national debt under each president starting from October of 1977 until October of 2024 can be found below.
Data provided by The U.S. Department of Treasury
The Impact on Interest Rates and Inflation
One of the most direct ways that deficits affect the equity markets is by driving up interest rates. When the U.S. borrows more frequently, it must offer higher interest rates to attract lenders. Higher rates, in turn, can dampen stock values, as they increase the discount rate applied to future earnings, thereby lowering their present value. Companies also face higher borrowing costs, which can curtail expansion plans and reduce consumer spending. And let’s not forget the bond market—higher bond yields can make stocks seem a little less attractive by comparison.
Deficits can also stir inflation concerns. When the government borrows heavily, especially during periods of low unemployment and strong economic growth, demand can outstrip supply, pushing up prices. And as inflation rises, so do interest rates, as lenders demand compensation for the expected higher prices in the future. It’s a bit of a vicious cycle—deficits, inflation, interest rates—all feeding on each other.
The Fed: Stepping In, As Usual
As we have witnessed since 2022, when inflationary pressures are mounting due to contributors such as deficit spending, the Federal Reserve has and may have to continue to step in and raise short-term interest rates to cool down the economy since the Fed has a mandate for price stability. However, such actions can lead to market volatility, as investors reassess what they’re willing to pay for risk assets such as stocks in a higher-rate environment. In other words, things can get a bit volatile when the Fed plays the role of an economic counterbalance to fiscal policy with monetary policy.
Crowding Out: Less Room for Private Investment
As the government borrows more, there’s a risk of crowding out private investment. Essentially, all of the government borrowing can divert capital away from the private sector, making it more expensive for companies to access capital through public markets. This often results in higher interest rates for businesses looking to borrow—for new projects, innovation, or expansion—none of which is geared for long-term growth. This impact is particularly pronounced in industries that rely on heavy capital investment, like manufacturing and technology.
Investor Sentiment: Uncertainty Looms
Investor sentiment is sensitive to the government’s fiscal health. Persistent deficits can cast doubt on the government’s ability to manage its debt load, eroding confidence in the broader economy. If investors start questioning the government’s sustainability, they might shift to safer assets or even assets outside of the domestic United States, reducing exposure to equities in favor of bonds or other lower-risk investments. This creates a demand profile change for risk assets and a flight to other frameworks to invest capital.
Reduced Spending in Other Key Areas
While deficit spending can provide a short-term boost, the long-term consequences are less glamorous. As deficits grow, the U.S. faces higher interest expenses, which leaves less room for productive government spending in areas like infrastructure, education, and research. Over time, this lack of investment could stifle economic growth and significantly reduce corporate profitability, which may lead to more subdued stock market returns.
A Weakened U.S. Dollar
Large deficits can also weaken the U.S. dollar. If global investors lose confidence in the government’s ability to manage its debt, they may decide to invest elsewhere. This would weaken the dollar, making imports more expensive and adding another layer of inflationary pressure. On the bright side, a weaker dollar can help U.S. companies sell more overseas, giving a bit of a boost to certain sectors of the stock market. But the overall picture of the impact of deficits on the dollar remains a tricky balancing act.
Can Deficits Ever Be a Good Thing?
Despite all the doom and gloom, deficit spending isn’t entirely without merit, especially in the short term. Borrowing can stimulate economic activity, boost consumer spending, and drive corporate profits. In fact, we’ve seen significant deficits for decades, yet the stock market has continued to perform well. The recent 2020-2021 period is a perfect example—government spending played a critical role in reviving the economy after the COVID-19 shutdown.
What Can We Do About the Debt?
So, is there a way out of this financial puzzle? Generally, there are three options: grow your way out of debt, inflate your way out, or—least likely—default.
Growing the economy is the best option, as it increases tax revenue, and if spending is kept in check, the debt can be managed. Inflating your way out involves printing more money, which can devalue the currency but makes debt repayment easier in "cheaper" dollars. Historically, a mix of growth and inflation has helped manage our debt.
Conclusions and Recommendations
US deficits are complex in their impacts on interest rates, inflation and the stock market. Although the effects of deficits can be positive in the short run, in the long run, the ramifications of high debt levels can have negative impacts on interest rates, inflation, and (reduced) investor confidence. Deficits may also make the job of the Fed more difficult as they add yet another variable to its decision-making process.
As our total debt now exceeds the annual output of this country, and interest rates and servicing cost on the debt are no longer near 0%, there is once again renewed focus on this issue. As investors, it is not only imperative to monitor the situation closely, but also, we must neither overreact nor underreact to its importance.
The time may come when the size of our nation’s debt will matter to bond markets, and thus may influence all risk assets as well. In fact, in 1983, strategist Ed Yardeni coined the phrase “bond vigilante” in an attempt to talk about a market’s breaking point for not lending any more money until discipline is re-instituted back into the system. These bond investors, in essence, withhold money from the market (pushing up interest rates), forcing the lender to change their ways. So, it’s all about a breaking point. After all, if one was worried about deficits impacting investment decision and outcomes, one would have been losing sleep since the 1980’s, and missed out on decades of strong equity market returns in the process.
We continue to recommend that clients not change their asset allocation due to current deficit levels. With interest rates falling and a diversified economy that continues to remain resilient, we believe, at least for now, these two issues will dominate investor’s attention and provide enough horsepower to make our debt levels manageable. For now, the over 50 all-time highs that the S&P 500 has made this year have shown that markets are not yet thinking the deficit is at “crisis” levels. Of course, we will remain diligent as we assess this ever-changing situation, and communicate with you, if we see any reasons for greater concern.
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