Navigating the US debt landscape

The US debt-to-GDP ratio has been on a deteriorating trajectory over the last decade, reaching 120% as of the second quarter of 2024. This is driven by persistent budget deficits, stemming from a gap between revenues (mainly from taxes) and outlays, including mandatory spending on programmes like Social Security and health care, as well as interest payments on debt.

Health care costs are projected to rise from 5.6% to 8.3% of GDP over the next 30 years, further pressured by demographic shifts and depleting trust funds (Source: ABN AMRO, US Elections – Spiraling debt is base case, 2024). Net interest payments are also expected to increase due to persistent deficits and potential demand for higher risk premiums.

Moderate economic growth may offer some revenue potential but is unlikely to fully address the fiscal gap. Rising entitlement costs, especially in health care, remain a significant concern. Rising interest rates could further complicate these challenges by increasing debt servicing costs. Trump's policies, such as reducing immigration and promoting on-shoring activities, could also negatively influence US debt and deficit levels. These measures, while aiming to boost employment, may impair growth and exacerbate deficits due to reduced revenue with an ensuing increase in public borrowing.

Projections by the Congressional Budget Office (CBO) indicate the US debt-to-GDP ratio reaching 166% by 2054, with interest payments accounting for much of this deterioration. The potential for higher risk premiums could increase the interest burden. Should it ever become a reality, a US public debt crisis would likely be multifactorial (economic, political, military, environmental) rather than solely spurred by a rise in the debt-to-GDP ratio.

In that sense, geopolitical factors and military expenditures could further impact the US debt landscape. Furthermore, US fiscal policies have global implications, affecting European sovereign debt through changes in monetary policy and exchange-rate fluctuations. Rising debt levels and debt ceiling discussions could lead to higher interest rates, limiting the government’s ability to stabilize the economy during crises.

The fiscal landscape for investors is characterized by a dual narrative. Rising interest rates make US Treasuries more appealing in the short term, offering higher yields and attracting risk-averse investors seeking stability. However, this allure may diminish if the US government fails to address its growing debt and fiscal deficit, potentially leading to higher risk premiums and increased borrowing costs. This could significantly impact the risk-return dynamics of fixed income investments, emphasizing the importance of monitoring fiscal policy developments.

As US government debt rises, increased Treasury issuance may drive up yields, raising also borrowing costs for corporations, since corporate bonds often price relative to Treasury yields. This can compress corporate profit margins and complicate refinancing, particularly for companies with weaker credit ratings. In addition, due to the crowding-out effect as government debt attracts more capital and leaves less available space for private investment, corporations may find it harder to secure funds or may face less favourable terms.

Persistent high debt levels can also raise concerns about the US government's creditworthiness, potentially affecting corporate credit ratings. This perceived increase in systemic risk could reduce demand for corporate bonds, particularly from lower-rated issuers.

Moreover, inflationary pressures derived from high deficits or possibly exacerbated by past central bank policies (like quantitative easing), can erode real returns on fixed-income investments, driving investors to demand higher yields and increasing corporate borrowing costs. Inflation uncertainty can add volatility to the fixed-income market, affecting liquidity and investor confidence.

Despite the substantial and growing debt burden, an immediate financial crisis is not anticipated. However, large deficits can constrain governmental spending priorities and crowd out private capital, potentially impeding growth as well as diminishing fiscal space that could be indispensable to face any future adverse conditions. This challenging debt path is expected to come under scrutiny in 2025, when tax policy debates are anticipated.

In the short term, we do not foresee any systemic risk concerns related to the US public debt situation. Instead, our attention will be on the impact of the new Trump administration on the markets and how forthcoming reforms might shape the Treasury yield curve. We anticipate that the Federal Reserve will continue to cut rates, although at a slower pace than previously expected, due to our projections of renewed upward inflationary pressure in 2025. The Federal Reserve policy rate is expected to stabilise at 3.5% by the end of 2025. Additionally, we still expect the US economy to grow at a slow pace in the coming quarters. Despite modest growth and rather high interest rates levels, US credits should remain resilient unless inflation increases excessively.

In the longer term, navigating the US debt landscape requires strategic foresight and international collaboration. For investors, understanding these dynamics is crucial for informed decision-making. Policymakers must prioritize sustainable fiscal practices to transform the US public debt narrative from one of uncertainty to resilience and opportunity.

High US debt and deficit levels can lead to increased interest rates, widened credit spreads, crowded-out private investment, heightened inflation risks and potentially reduced investor confidence — all factors that strain the corporate fixed income market. A balanced approach addressing both revenue and spending is essential to avert a debt spiral.

Florian Bardy