Large U.S. Deficits and Bond Yields: What’s the Deal?

 

Ever since Trump won the election, there’s been a lot of buzz about government deficits and their impact on bond yields. Let’s break it down without getting too technical.

 

Why Are Deficits a Big Deal?

Government borrowing is like running a tab that’s eventually paid through taxes, inflation, or more borrowing. If the U.S. (or any country) borrows too much, it can push bond yields higher because investors will want a bigger reward for lending money. Higher bond yields can make it more expensive for everyone to borrow, from governments to businesses to everyday folks trying to get a mortgage.

 

Deficits matter because they signal how much the government is spending versus how much it earns in revenue. When deficits get too big, they raise concerns about sustainability—will the government be able to keep borrowing at reasonable rates, or will investors start demanding sky-high yields?

 

The Current Situation

 

Right now, government borrowing is high, but when you look at the big picture (including private borrowing), the overall debt situation isn’t out of control. Total credit creation—fancy talk for how much debt is being taken on—is about average. Inflation is calming down, and bond markets don’t seem panicked. So, things are relatively balanced.

 

Let’s break this down:

 

• Government borrowing: High but not unprecedented. The U.S. has run higher deficits during crises like the Great Financial Crisis and COVID-19.
• Private borrowing: Lower than average. Higher interest rates have made it less attractive for businesses and households to take on new debt.
• Inflation: Cooling off. This reduces pressure on the Federal Reserve
•  

Here’s what’s worth watching:

 

• The yield curve: If long-term rates rise faster than short-term ones, it could mean investors are worried about too much borrowing.
• Debt-to-GDP ratio: When total debt compared to the economy’s size goes up, it’s a red flag.
• Currency strength: If the dollar weakens, it could be a sign of trouble.
•  

A Global Perspective

 

It’s not just the U.S. playing this game. Around the world, governments have been borrowing heavily, especially during crises like COVID. But here’s the thing: overall debt levels (relative to GDP) are either flat or falling in most developed countries. That’s a good sign that things aren’t spiraling out of control.

 

Let’s consider why this matters:

 

• In the developed world, governments often borrow more during recessions or crises to keep their economies afloat. Once the economy stabilizes, debt levels should ideally fall or at least stabilize relative to GDP.
• Total borrowing—including both public and private debt—is a key metric. If private borrowing drops while public borrowing rises, the overall balance might still be sustainable.

 

What Could Go Wrong?

 

If the government keeps borrowing like there’s no tomorrow and the private sector can’t cut back enough to balance things out, we might see real problems. Here are the potential risks:

 

• Inflation spike: Too much borrowing can drive inflation higher, forcing the Federal Reserve to raise rates aggressively.
• Crowding out: When the government borrows heavily, it can push private borrowers out of the market by driving up interest rates.
• Debt sustainability: At some point, investors might lose confidence in the government’s ability to manage its debt, demanding even higher yields.

 

Higher deficits could push inflation up, forcing the Federal Reserve to hike rates even more. But for now, inflation seems to be keeping policymakers in check.

 

Why Bonds Are Still Attractive

 

Despite the high deficits, bonds are looking pretty good these days. Here’s why:

 

• Real yields: That’s the interest rate after adjusting for inflation, and it’s higher than it’s been in years. For investors, this makes bonds a compelling choice.
• Diversification: Bonds are a great hedge for equity-heavy portfolios. If stocks stumble, bonds often hold steady or rise.
• Relative value: With stock earnings yields (the inverse of the price-to-earnings ratio) roughly matching bond yields, bonds are competitive.

 

Banks and big investors have been slow to jump back into the bond market, but that could change if regulations ease or the yield curve steepens. Higher yields make bonds more appealing, and we might see more demand from institutional players if market conditions shift further.

 

What’s Next?

 

The bond market seems to think the U.S. economy is strong enough to handle these high rates without needing a big Fed intervention. Inflation expectations are stable, and most of the recent moves in yields are tied to real factors, not just fear of inflation.

 

In short, while the U.S. deficit is worth keeping an eye on, the bond market’s reaction suggests we’re not heading for a debt-driven crisis anytime soon. Just keep an eye on the usual suspects: inflation, interest rates, and global economic trends. For now, the system seems stable, but vigilance is key.

 

 

All my best,

 

Brandon VanLandingham, CFA, CMT, CFP