Key takeaways
The growing U.S. national debt is drawing increased attention.
Estimated national debt in mid-2024 stands at more than $34 trillion, a record amount that has doubled over the past 15 years.
A major concern is not just about the growing level of debt, but how today’s higher interest rate environment affects debt repayment.
Today’s higher interest rate environment has magnified the issue related to growing U.S. federal government debt. While expanding debt has long been a concern, it tends to gain more attention during election years, and also at times when the government’s interest costs become more significant. Debt has risen steadily in recent years, and as of mid-May 2024, the national debt stands at $34.56 trillion.1 The nation’s debt has essentially doubled in just 15 years and represents the impact of accumulated deficit spending.
Government debt is financed through issuance of U.S. Treasury bills, notes and bonds. Treasury has been required to issue increasing amounts of debt in recent times. 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 dramatically in recent years, to 3.23% as of April 30, 2024.2
“The U.S. government is now paying more interest, requiring further debt issuance,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The proportion of the federal budget required to maintain the national debt has grown significantly.” To what extent does this raise issues for the U.S. economy and the 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, but so far, this hasn’t been a problem.”
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. “Now, even as inflation decelerated, the U.S. economy demonstrated surprising strength, which also likely had an impact on investors’ expectations for interest rates.” Both faster growth as well uncertainty over the timing of a Fed shift in monetary policy including the potential for interest rate cuts, contribute to elevated bond yields, according to Merz.
Other considerations come into play as well. “One key factor is the supply of bonds relative to the demand by bond buyers,” says Merz. 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.”
Treasury bond issuance has increased to cover rising debt levels. The U.S. Treasury borrowed $748 billion in the first quarter of 2024 with plans to borrow another $243 billion in the second quarter, and $847 billion in the third quarter.3 While Treasury debt supply expands, concerns were raised over a potentially shrinking pool of Treasury buyers. Most notable is the Fed, which propped up the bond market for years following a “quantitative easing” protocol that involved regular purchases of Treasury and mortgage-backed securities. In early 2022, the Fed ended that program and began a “quantitative tightening” strategy, winding down its balance sheet of bond holdings by redeeming $60 billion per month in Treasury securities and $35 billion per month in mortgage-backed securities. In May 2024, Fed chair Jerome Powell announced that starting in June, the Fed would reduce “the monthly redemption cap on Treasury securities from $60 billion to $25 billion.”4 That means less Fed Treasury bond redemption on a monthly basis, the equivalent of keeping $420 billion working in the bond market over the next year that was scheduled for redemption.
“This change in Fed policy relieves some Treasury market stress,” says Haworth. “But this level of tapering quantitative tightening is easily outweighed by the growth of the fiscal deficit.” 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.
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.
“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 Bill Merz, head of capital markets research at U.S. Bank Wealth Management.
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.
A combination of growing expenditures and tax revenues that can’t keep pace will result in larger projected yearly deficits for the foreseeable future. As a result, continued growth in the total national debt is projected.
To help put the debt in 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, according to most recent projections from the Congressional Budget Office, exceed 172% (meaning debt will be close to double the nation’s economy).5
While these numbers appear unfavorable, it isn’t clear when debt becomes unsustainable or has a negative impact on economic growth. Such residual effects are possible because increased taxes lower federal government spending or both, aimed at lowering the debt, could be detrimental to the economy. “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 they are not yet on voters’ radar, so Congress hasn’t yet seriously considered solutions to them.”
While growing government debt draws increasing attention, an important question for investors is what the potential impact is on the long-term interest rate environment. What could it mean for fixed income and equity portfolios?
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.
Haworth says interest rates matter for equity investors because higher rates make bonds more competitive with stocks. “When the Fed began raising interest rates in 2022, price-to-earnings multiples for stocks were compressed.” In other words, investors demanded evidence of higher earnings to push up stock prices. “With interest rates stabilized since mid-2023, we’ve seen no further compression. Stock valuations are higher today, reflecting both higher earnings and expectations that rates will likely go down from here,” says Haworth. “If we are surprised and interest rates reset significantly higher from here, it could put more pressure on stock prices.”
Investors may wish to consider overweight positions in equities and real assets (such as commodities and real estate) 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.
The rate on debt issued by the U.S. Treasury varies constantly. Therefore, the rate paid on debt issued on specific dates will differ from day-to-day. In terms of the accumulated Treasury debt securities outstanding on the open market, the average interest rate paid by the government was 3.23% as of April 30, 2024. That’s more than 1% higher than where the average rate stood at the end of 2022.2
Government debt, funded by U.S. Treasury debt securities, is funded by a variety of buyers. The largest group of buyers are foreign entities (governments, institutions and individuals) who own close to 30% of the debt. The Federal Reserve Bank is also a major buyer, but since 2022, the Fed has reduced its Treasury debt holdings. Individuals and mutual funds are taking on a more important role as buyers of U.S. debt. (Source: U.S. Bank Asst Management Group analysis.)
Debt represents a shortfall of revenue to meet all current expenses. In May 2024, that debt equaled more than $34.5 trillion.1 The U.S. federal debt represents accumulated federal government deficits over a period of years. In most years, Congress, when it approves spending measures, is not required to balance the budget. Without sufficient tax revenue and fees to meet approved expenses, a deficit results, adding to the federal debt.
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