America’s worsening fiscal outlook and mounting government debt are hiding in plain sight, but that troubling mix may not get a pass from investors for much longer.
President Donald Trump’s tax cuts and new federal spending have fueled a budget deficit that the Congressional Budget Office predicts will reach $1 trillion in 2020. With the Federal Reserve also winding down its debt holdings, that’s forced Treasury Secretary Steven Mnuchin to lift note and bond sales to levels last seen in the aftermath of the recession that ended in 2009.
The upshot is surging government debt that has more than tripled since 2007, generating a tailwind for yields, though so far they’re still relatively low thanks in part to ongoing global demand for the safe haven of dollar assets.
While Americans are feeling the immediate benefits of Trump’s fiscal largesse, with U.S. economic growth above 4 percent in the second quarter and unemployment at 3.9 percent in July, economists worry it will curb policy makers’ ability to fight the next downturn.
“We are in an environment of an unprecedented economic experiment where the U.S. government is increasing the deficits quite strongly at a time when we are at full employment,” said Frankfurt-based Christoph Rieger, head of fixed-rate strategy at Commerzbank AG. “And the sheer size of the Treasury supply numbers are so huge. If the experiment goes wrong, we are talking about a serious risk off.”
Rieger lifted his year-end 10-year Treasury yield forecast to 3.15 percent from 3 percent following the Treasury department’s announcement on Aug. 1 of plans to sell $78 billion in long-term debt over the coming three months — the biggest quarterly amount since 2010. The catalyst for the forecast change was risks of increased issuance and the resilience of U.S. economic activity. The benchmark yield was 2.95 percent at 5:10 p.m. on Friday.
Net Treasury issuance will more than double this year to $1.44 trillion and remain high at $1.36 trillion in 2019 , JPMorgan Chase & Co. predicts.
The Trump administration argues that faster economic growth will help boost tax revenue and reduce the deficit. That’s not happening yet. Tax revenue in the second quarter was little changed from the year-earlier period.
“It’s crazy that we’ve allowed ourselves to become this vulnerable to interest rates going up, which is a very likely and sensible scenario that will happen,” said Maya MacGuineas, president of the nonpartisan Committee for a Responsible Federal Budget in Washington.
What the U.S. pays now is “like a credit-card teaser rate,” said MacGuineas, who added that CRFB calculations show debt service costs rise by $150 billion to $200 billion per year (or up to $2 trillion over the next decade) for each 1 percentage point increase in average interest rates.
“Ultimately the concern over the fiscal situation today will be much louder, and it should be, than it was during the time of the economic crisis,” she said.
Fed interest-rate increases and inflation picking up have already buoyed annual interest costs on the nation’s debt to the highest to the highest ever in fiscal 2017.
The key drivers to the current and projected rise in interest costs are the size of the debt load itself and Treasury yields, the CBO wrote in an April report. The non-partisan group predicts outlays for net interest costs will nearly triple by 2028.
Economists worry that fiscal expansion when U.S. unemployment is near its lowest level in 50 years could stoke inflation and push up borrowing costs, risking a recession at a time when Congress will have less ability to respond with fresh spending.
“We are heading to $1 trillion annual deficits and therefore $1 trillion annual borrowing,” said Harvard University economist Martin Feldstein, who was a top economic aide to President Ronald Reagan. “That will push up long-term interest rates. That could depress the equity prices that are already very much overvalued.”
Falling stock prices that shrink household wealth and spending could potentially push the U.S. into a recession, but the scope for fiscal policy to provide a cushion will be limited, Feldstein said.
So far, though, U.S. government debt remains in demand as it offers a higher yield than other relatively safe assets such as German or Japanese government bonds. And the prospect of a trade war between the U.S. and China is helping to maintain its attractiveness as a haven. As a result, benchmark 10-year U.S. Treasury yields have failed to sustain a rise above 3 percent for very long.
The U.S. has typically boosted spending and cut taxes in response to economic downturns, deploying so-called “counter-cyclical” policy. The current fiscal expansion represents the first major “pro-cyclical” fiscal action since the 1960s, Bank of America Merrill Lynch global economist Ethan Harris wrote in a report Friday.
“We are currently experiencing the most radical pro-cyclical policy outside of war-time, perhaps ever,” said Jeffrey Frankel, an economist at Harvard University in Cambridge, Massachusetts, and a former economic adviser to President Bill Clinton. “This is an especially bad time to raise the budget deficit not just because of business cycle timing, but also because of the demographic timing: the ongoing retirement of the baby boom generation means huge deficits in Social Security and Medicare are coming.”