Federal debt issue brushed aside, again

Amid the drama of the presidential debate last week came a question that should have garnered much more attention. CNN moderators asked Biden and Trump about the rapid accumulation of federal debt over the last eight years. U.S. Treasury debt held by the public has doubled over that period, while nominal GDP grew only slightly over 50%. That has driven the U.S. debt-to-GDP ratio from the low 70s to almost 100%. The Congressional Budget Office projects the ratio will surpass 100% and keep climbing in the next few years, breaking the record reached at the end of World War II.

Economists, investors and the financial media have voiced concerns about the deficit and rising federal debt for decades. The two candidates, however, failed to clearly answer what they plan to do about it. Trump talked about cutting tax rates again, then wandered off into complaints about the Covid vaccine mandate and illegal immigration. Biden brought up raising taxes on the wealthy, but then trailed off in apparent confusion. In fairness, few politicians have addressed this issue in any substantive manner. Putting one’s head in the sand has not hurt them because the rising debt has not materially impacted market interest rates. We think that is changing. Despite the nonchalance of those in Washington, the deficit/debt issue will become more important in the Treasury market heading into the election and thereafter for the following reasons:

• The analyses that conclude debt and deficits do not push market yields up were completed when debt to GDP was much lower. As recently as 2009, this ratio was about 50%. 
• The sheer dollar volume of auction sizes of government securities has reached records at a time when the capital committed to market-making by the primary dealers has remained attenuated, contributing to rising Treasury-market volatility.
• Neither major political party likely will act to restrain the growth of the debt: 
  • Republicans are willing to cut taxes despite large deficits (partly based on the dubious notion lower taxes will generate enough growth to pay for the tax cut). Sure, Congressional Republicans invoke deficits to counter Biden administration policies, but they were silent on the matter when Trump was in power and likely will repeat that approach if he returns to the White House.
  • Democrats seem always willing to spend more. They often say they want to pay for spending with tax increases but have largely failed to do so in the last four years. That is partly due to unwillingness to raise taxes by some key moderate Democrats. As a result, the higher spending has been financed by a wider deficit.

An imminent debt crisis in which the Treasury Department faces failed auctions and yields spike is not likely; demand for U.S. government debt is still deep and vast. That said, the increasing and persistent fiscal imbalances likely will contribute to a widening risk premium, raising Treasury yields above levels that would otherwise prevail given other relevant factors, such as growth, inflation and Federal Reserve policy.

The net effect is higher interest costs for Treasury and others—including local governments, corporations, and home buyers—whose debt is benchmarked off Treasury yields, imposing costs on essentially everyone. Unfortunately, it seems no matter who wins an election, the issue does not grab sustained attention. The Treasury market should brace for more of the same...and much more debt.