The impact of U.S. national debt on your investments

With election years in full swing, an issue likely to garner more attention is America’s growing federal government debt. While concerns are raised about the increasing amount accumulating on the nation’s “credit card,” it’s important to keep America’s debt situation in the proper perspective. It’s a challenge that policymakers have yet to adequately address. At the same time, the problem appears to be far from a crisis. However, rising national debt has potential capital market ramifications.

America’s debt has risen steadily in recent years, and as of the end of July 2024, stands at more than $35 trillion. ¹ The dollar figure has essentially doubled in the past 15 years, and based on current fiscal policy, is poised to continue rising.

One reason the debt issue has taken on great significance in recent times is the rising cost of servicing that debt in an environment featuring higher interest rates. Government debt is financed through issuance of U.S. Treasury bills, notes and bonds. The U.S. Department of the Treasury has been required to issue increasing amounts of debt to fund government operations. The recent upturn in interest rates means the cost of financing government debt is more expensive. According to the U.S. Treasury, the average interest rate for all federal government-issued interest-bearing debt has jumped in recent years, to 3.28% as of June 30, 2024. ² The average interest rate paid today is more than double what it was in 2020.

director at U.S. Bank Wealth Management. “The proportion of the federal budget required to maintain the national debt has grown significantly.” The question for investors, however, is whether an increase in Treasury debt issuance can potentially impact the fixed income and equity markets. “Eventually, if debt requirements result in more Treasury supply, pushing interest rates higher, that can create challenges for equity markets, says Haworth. “Higher bond yields may lead investors to put more money into fixed income instruments rather than into stocks.”

Yet Haworth notes that despite the concerns recently raised about the impact of rising debt, it hasn’t had a material market impact. “Although the U.S. Treasury is required to issue more debt, the impact on the interest rate environment has been modest,” says Haworth. “If deficits expand to a point where the Treasury is issuing more 2-year, 5 -year and 10-year bonds, we could see more of an impact.”

Living in a period of higher interest rates

Three of the primary interest rate drivers are the Federal Reserve’s (Fed’s) policy rate, economic growth and inflation.. Beginning in 2021, inflation began climbing quickly, and interest rates followed soon after. The Fed also responded to the resurgence of inflation by raising its target federal funds rate by over 5% from near zero between March 2022 and July 2023. As shown here, the yield on the benchmark 10-year Treasury note has, in recent months, traded at its highest levels since 2007.

“Initially, higher bond yields reflected rising inflation,” says Bill Merz, head of capital market research at U.S. Bank Wealth Management. However, even with inflation reduced from peak levels, rates stayed elevated due to a stronger than expected economy and delays in potential Fed rate cuts, according to Merz. He says another key factor that can affect bond yields, “is the supply of bonds relative to the demand by bond buyers.” If the Treasury needs to issue more bonds, that results in greater supply. “In that event,” says Merz, “more supply might result in buyers demanding higher interest rates to absorb the expanded issuance.”

The U.S. Treasury borrowed $748 billion in the first quarter of 2024 and another $234 billion in the second quarter. It projects a need to borrow an additional $740 billion in the third quarter, which is more than $100 billion less than it initially projected. The Treasury currently estimates that fourth quarter 2024 borrowing will add another $565 billion in privately-held net marketable debt. ³

While Treasury debt supply expands, concerns were raised over a potentially shrinking pool of Treasury buyers. Most notable is the Fed, which began a “quantitative tightening” strategy, winding down its balance sheet of bond holdings by redeeming a portion of its Treasury securities rather than purchasing Treasuries, as it did prior to 2022. Along with the Fed’s reduced role in Treasury purchases, foreign buyers also play a diminished role. “China is less likely to expand its Treasury holdings if it doesn’t have as many dollars to invest based on reduced U.S. trade, and Japan is focused more on internally funding its own debt,” says Haworth. As a result, individual investors, either through direct purchases or via mutual funds, have taken on a much larger role as Treasury debt purchasers.

Can rising government debt result in higher interest rates?

Merz notes that long-term fiscal viability and credit issues can, in certain circumstances, become factors that influence bond yields. “If investors become concerned with the U.S. Treasury’s ability to make good on its debt and avoid default, that could have an impact on interest rates,” says Merz. Credit agencies such as Fitch, Standard & Poor’s and Moody’s have either downgraded credit quality of U.S. Treasury issues or issued warnings about potential future downgrades.

Yet the issues created by the national debt don’t appear to be immediate. “The government’s debt is manageable today,” says Merz, “but its ability to sustain rising debt levels over time is the issue that concerns some investors.” A key question, according to Merz, is how quickly the government addresses the challenge. He says the sooner the long-term debt problem is addressed, the less painful it will be to resolve.

Can the U.S. economy sustain such high government debt?

For perspective, analysts frequently compare the total national debt to the nation’s gross domestic product (GDP), which measures the size of the economy. In 2023, for example, the nation’s total publicly held debt amounted to 97% of the full value of the economy as measured by GDP. By 2054, the debt-to-GDP ratio will reach 172% (meaning debt will be close to double the nation’s economy), according to most recent projections from the Congressional Budget Office. ⁴

Yet it isn’t clear at what point debt becomes unsustainable or has a significantly negative impact on economic growth. “Many developed countries, such as Japan, have faced high debt-to-GDP levels, and still found ways to grow their economy,” says Merz. Haworth says the more a country’s citizens own the debt (as opposed to central banks or foreign buyers), the more markets will be forgiving about the size of the debt.

Haworth also points out that much of the nation’s long-term debt problem centers on funding commitments for Social Security and Medicare. “We have an aging population and fewer workers in succeeding generations to pay the costs of these programs,” says Haworth. “These are manageable budget matters, but Congress hasn’t yet seriously considered solutions to them.”

Potential investment implications of the rising national debt

In order to reduce the debt, Haworth points out that the government must first eliminate deficit spending on an annual basis. “Next, you need to pay down debt, and that too will take money out of the private sector.” This is due to increased taxes, lower federal government spending, or both, aimed at lowering the debt, which could take a toll on the economy.

Merz believes the U.S. position relative to the global economy remains strong, which allows the federal government more time to address the debt situation before it results in significant economic ramifications.

As for the investment implications, a larger supply of bonds might put some upward pressure on interest rates, though that doesn’t yet seem to be a significant concern. Haworth says interest rates matter for equity investors because higher rates make bonds more competitive with stocks. “With interest rates stabilized since mid-2023, stock valuations are generally higher today, reflecting both higher earnings and expectations that rates will likely go down from here,” says Haworth.

Investors may wish to consider overweight positions in equities to capitalize on continued economic growth and to counter higher inflation. Fixed income holdings may be positioned with a modestly less-than-neutral weighting. However, Treasury securities and other fixed income investments should continue to play an important role in a broadly-diversified portfolio. U.S. Bank will closely monitor the government’s increasing debt burden and policies that influence long-run sustainability for signs of change in the broader investment landscape. Consider talking with your financial professional to make sure you have a comfort level with your current plan and investment position.