There's another reason bond yields may stay higher for longer

Will interest rates stay higher for longer? Most often, investment managers answer this with a focus on the future path of inflation. But, there’s another area that could be a key driver: US government debt. In this article, we look at the factors pushing government debt up and how higher debt levels could influence markets. We believe that the yields (or interest paid) by government bonds will remain elevated for an extended period. Investors may be drawn to the higher yields, seeing them as preferable to riskier investments like stocks.

The question of sustainability

Since 2001 the US government has spent more than they’ve earned. Over the last 23 years, US government debt as a percentage of GDP has risen from c.55% to 120%¹. Debt has spiked due to cheap borrowing, wars, the COVID-19 pandemic, and initiatives by President Biden to boost growth. Federal spending increased by 50% from 2019 to 2021².  

Debt is considered sustainable when a government can pay its present and future bills without needing financial assistance. The sustainability of the US debt has rarely been questioned historically due to several factors: the size of its economy, strong economic growth and the global demand for dollars.

Higher interest rates have raised the cost of debt servicing. High debt can lead to a damaging loop where rising debt results in increased interest payments, necessitating the issuance of further debt, which then increases interest payments further.

Demographic headwinds affecting revenues and spending

Governments benefit when the economy grows, by generating more revenue from taxes on individuals and businesses. This means they can spend more money and/or borrow less. According to the International Monetary Fund (IMF), the US economy is expected to grow by 2.7% in 2024, and then slow to 1.9% by 2025³. Looking forward, economic growth may be slower than in previous decades due to demographic headwinds and this may impact government revenues.

The national debt has soared due to ongoing budget deficits, which are expected to reach 8.5% of GDP by 2054 according to the Congressional Budget Office⁴. A large driver for spending is associated with demographics, and the population. The charts below show the projected spend of the US government as a percentage of GDP. Healthcare spending is a large proportion of projected future spend.

Government Projected Spending, by Category

Source: Congressional Budget Office, The Long-Term Budget Outlook: 2024 to 2054, March 2024

Spending cuts are unlikely

If elected, Donald Trump and US President Joseph Biden are both likely to pursue policies that increase borrowing. They won’t want to cut Medicare, social security and national defense spending, which represent nearly 47% of government spending.²  There are opportunities for the government to increase revenues. Spending and support for research and development can have a positive impact on growth. This, coupled with trade agreements and policies to support entrepreneurship, has the capacity to increase economic growth.⁵

Monetary Policy - Tackling Inflation

High levels of government debt were less of an issue when interest rates were low. This kept the debt servicing costs low. In 2020 interest rates were at 0.25% pa versus today’s levels of 5.25%-5.50% (as of the Federal Reserve’s May 2024 meeting). If interest rates remain elevated to tackle inflation, then the burden of paying interest on the national debt becomes more of a challenge.  It causes the cost of servicing debt to increase.

So, why does this matter?

US government debt is important globally. It is considered a risk-free investment because investors widely believe that the US government will always pay its debts. Ongoing budget deficits will require increased government borrowing.  This means the government will issue more bonds in the market, and someone has to buy those bonds. The US Federal Reserve has stepped back from purchasing US treasuries, so it’s likely investors will be the main buyers. Investors will want to be compensated fairly for the risk they take on. Supply and demand also have to balance; the US government will have to sell its bonds at a rate that investors are willing to accept. If the bond ‘supply’ remains high, then this is likely to keep the yields on the bonds high.

The yield investors receive on US government debt is a benchmark for other investments. Investors expect to be compensated more for assets that carry more risk than U.S. government bonds. So, if US government bond yields stay high it could also keep yields for the bonds from other nations elevated. Sustained elevated rates would also set a more challenging benchmark for other riskier investments like stocks to outperform. If you can receive a 5% pa return on a US government bond, then you’ll want a higher return from your stocks. This isn’t necessarily bad – it can enforce more discipline on companies to use their capital wisely and adopt shareholder friendly policies, like buying back shares and paying dividends.

Final thoughts

So, it’s not just inflation than may keep the yields on government bonds elevated. We think government bond yields will stay elevated, partly due to the high and rising levels of national debt. This differs from the market consensus, and is one of the reasons we have less in US Treasuries as part of our tactical views.

The longer-term positives from an investor’s perspective are: (1) you might be able to achieve your return objectives without taking as much risk as in the past and (2) higher interest rates can encourage better capital discipline for companies.

1.      Federal Debt: Total Public Debt as Percent of Gross Domestic Product (GFDEGDQ188S) | FRED | St. Louis Fed (stlouisfed.org)

2.      National Deficit | U.S. Treasury Fiscal Data

3.      World Economic Outlook, April 2024: Steady but Slow: Resilience amid Divergence (imf.org)

4.      The Long-Term Budget Outlook: 2024 to 2054 | Congressional Budget Office (cbo.gov)

5.      Fiscal Policy in the Great Election Year (imf.org)