Wall Street worries as crisis-level deficits become the government's default mode

Mint

14 hours ago

U.S. budget deficits were already approaching $2 trillion when Republican lawmakers set out to extend and expand tax cuts this year. Interest rates were high and the bond market was jumpy, producing worrying spikes in borrowing costs.
Republicans forged ahead anyway, defying warnings from Wall Street to Washington that they were pushing the country further down a dangerous fiscal path.
On Thursday, the House voted in favor of the sprawling tax-and-spending bill that was passed on Tuesday by the Senate.
The resulting legislation headed for President Trump's desk adds $3.4 trillion to federal deficits through 2034 compared with a scenario in which Congress did nothing, according to the Congressional Budget Office. The extent of the projected shortfall increased as the measure worked its way across Capitol Hill, as the Senate made some business tax breaks permanent.
Economists, investors and politicians have often warned that the U.S.'s growing debt burden would punish future generations. The market has been willing to tolerate spikes in borrowing during crises such as a war or Covid, seeing it as a logical, and temporary, response to a sharp growth slowdown.
What stands out now to those sounding the alarm the loudest is that America is bingeing on debt when there's no such emergency requiring it. The deficit as a share of the economy is already around the levels reached in the era of the 2008 financial crisis and the pandemic.
Many investors are concluding that financial profligacy isn't a bug, but rather a feature of U.S. policymaking. 'The government is like a teenager with a credit card that has no limits until it has to be paid," said Bill Gross, founder of Pimco. ''Payment due' comes not with default but with a weak dollar and higher interest rates."
Trump and his GOP backers in Congress dismiss those bleak projections and, armed with their own budget math, paint a very different fiscal reality. They say tax cuts will accelerate growth and, along with new tariffs and heavy cuts to social programs such as Medicaid, will actually put the nation on sounder financial footing.
The long-term verdict might be rendered in U.S. bond markets. The U.S. borrows money by issuing Treasurys, and an oversupply of those bonds would drive up yields, which rise when prices fall. Because interest rates on other debt are linked to Treasury yields, that would also lift costs on mortgages, car loans and corporate bonds.
The market has been calm lately. But it has sent warning flares about the fiscal trajectory, most recently in May when yields on 30-year bonds climbed close to a two-decade high.
Some investors, meanwhile, are concerned that massive debt projections are weighing on the dollar, which just posted its biggest first-half decline since 1973.
The deficit, or annual gap between government revenue and spending, was $1.8 trillion, or around 6% of gross domestic product, last fiscal year. Moody's estimates it will reach nearly 9% of GDP by 2035, pushing publicly held federal debt—or the sum of all the annual shortfalls—from a little under 100% of GDP now to more than 130%. That compares to the previous record of 106% in 1946.
Ken Rogoff, a Harvard University professor and former chief economist for the International Monetary Fund, said the U.S. is leaving itself little room to go on a borrowing binge when it really needs to.
'We typically look to borrow 20% or 30% of GDP in these big crises," he said. 'It's not clear markets will tolerate that."
Even if Congress wasn't adding new tax cuts this year, federal debt would grow from around $29 trillion to $50 trillion in 2034, according to the CBO. The bill's advance, though hardly unexpected on Wall Street, has dimmed budget hawks' already modest hopes that lawmakers would make deficit reduction more of a priority.
Ray Dalio, founder of Bridgewater, warns that staying on the current path will ultimately lead to some mix of a bond-market slide, a severe economic contraction or an inflation-fueling intervention by the Federal Reserve.
The GOP bill 'reflects a political system that favors indulging voters over prudence," he said.
Trump says skyrocketing growth will avert any downsides. 'For all cost cutting Republicans, of which I am one, REMEMBER, you still have to get reelected," he wrote in a social-media post shortly before senators began voting on the bill earlier this week. 'Don't go too crazy! We will make it all up, times 10, with GROWTH, more than ever before."
Members of Congress during the House vote on Thursday.
The U.S. government borrows money to pay for the shortfall between what it collects in taxes and what it spends on programs, such as defense and Social Security, by issuing Treasury securities that mature over varying periods of time. Buyers of this debt range from foreign banks to hedge funds to everyday investors.
In principle, Treasurys are subject to the forces of supply and demand, like any other item. If the government issues more Treasurys than investors want or need, it will need to win them over with higher interest rates. If investors are worried about that happening in the future, they will likely sell bonds now, causing an immediate jump in yields.
Treasurys, though, have long been viewed as the ultimate safe investment, especially in rocky economic times, because they are backed by the world's richest country and are effectively guaranteed to be repaid at maturity. That has historically kept America's borrowing rates in check, even as the volume of debt grew.
Yet deficit worries still go back a long way, in government and on Wall Street.
Peter Peterson, the late co-founder of the Blackstone Group who also served as President Richard Nixon's secretary of commerce, became concerned when planning for a talk on President Ronald Reagan's budget in 1981. Its big increase in defense spending and substantial tax cuts didn't make sense to him, and he was especially worried about the looming costs of Social Security and other entitlement programs.
'To put the matter bluntly, Social Security is heading for a crash," he wrote in a 1982 essay so long that the New York Review of Books split it into two parts. That same year, Salomon Brothers chief economist Henry Kaufman, known as Dr. Doom for his pessimistic forecasts, warned that proposed tax cuts and the resulting deficits would effectively block recovery from an ongoing recession.
Worries about the deficit flared up regularly in the decades that followed—taking a break in the 1990s when the Clinton administration briefly engineered a surplus. But the concerns were little more than minor impediments to a long bull market in bonds that dragged Treasury yields steadily lower.
Rogoff, the Harvard professor, who with Carmen Reinhart wrote the 2009 book 'This Time Is Different: Eight Centuries of Financial Folly," has long argued that high levels of debt can weigh on growth. A 2012 paper he wrote with Reinhart and her husband, Vincent Reinhart, found that for advanced economies since 1800, debt levels above 90% of GDP corresponded to significantly lower levels of growth.
The U.S. shot past that 90% threshold when the government spent massively in its efforts to bolster the economy during the pandemic. The overall level of America's GDP is significantly higher than what forecasters on the eve of the pandemic expected it would be in 2025, but Rogoff still thinks that at some level deficits matter.
'The appetite for U.S. debt may be very large, but it's clearly not infinite," he said.
The Department of Treasury building in Washington.
Nearly a third of publicly held U.S. debt is owned by foreigners, including foreign central banks. If they start worrying more about America's large debt load, they could become less willing holders.
A wholesale dumping of U.S. debt by foreigners—a doomsday scenario—is extremely unlikely, according to Jeremy Stein, a Harvard economist who was a Fed governor from 2012 to 2014. 'But I wouldn't be surprised if, over the next couple of years, as their portfolios roll off and they have to reinvest, they start shifting that reinvestment more towards, say, Europe or German bonds," he said.
Stein also worries that as the supply of Treasurys increases, hedge funds will become even bigger players in the market for U.S. debt. That could raise the odds of market disruptions, because fast-money traders occasionally run into problems that force them to sell.
A mix of factors has created the current fiscal imbalance, including recessions, an aging population and rising federal assistance to households. Those spending policies were largely championed by Democrats. Republicans, meanwhile, have led the charge in cutting taxes.
This year's budget negotiations revealed fissures among Republicans, with some expressing more concern about deficits than others.
With the 2017 tax cuts set to expire at the end of the year, many in the party argued that an extension shouldn't count as a deficit increase because it was merely a continuation of current policy.
Others, though, opposed that approach, citing concerns about national debt. House conservatives, led by Reps. Jodey Arrington (R., Texas) and Lloyd Smucker (R., Pa.), along with others such as Rep. Chip Roy (R., Texas), forced the House's budget framework to link tax cuts and spending cuts, with no more than a $2.5 trillion gap between them. By that approach, if the House could find $2 trillion in spending cuts, it could have $4.5 trillion in tax cuts. If it could only find $1.5 trillion, the tax cuts would have to shrink, too.
'We can't continue to have quote, a free lunch, by just saying that every single tax cut pays for itself," Roy said in an April interview.
The House, on May 22, passed a version of the tax bill that adhered to those demands. CBO estimated that it would cost $2.4 trillion over a decade.
In June, 38 Republicans led by Smucker signed a letter saying they wouldn't support legislation coming back from the Senate that violated their framework. Doing so, they wrote, 'would invite higher borrowing costs and undermine the economic growth that Americans need."
In the end, though, it is estimated the Senate's version of the legislation would add $1 trillion more to the deficit over the next 10 years than the House bill—well above what those House Republicans said they would accept. All of them voted for it anyway on Thursday.
Johnson showed the tally of the vote in the House on Thursday.
The question of how much deficits matter ultimately depends on the bond market—and the corresponding effect on borrowing costs for businesses and consumers.
Worries about government borrowing have already caused a couple of selloffs in Treasurys over the past two years.
One came two summers ago, when the Treasury Department announced that it would need to borrow more than investors had expected in the coming months. Another occurred in May, after Moody's became the last major ratings firm to downgrade the U.S. to below triple-A.
In both cases, the selloffs were temporary. Bond prices rebounded and yields fell, suggesting to some analysts that investors are only sporadically worried about deficits. Others, though, note that yields on longer-term Treasurys, in particular, are higher than what would be expected based just on the projected path of short-term rates set by the Fed.
That extra yield, known on Wall Street as a term premium, can only be estimated. But one popular estimate, published by the Federal Reserve Bank of New York, indicates the premium for the 10-year Treasury note has reached its highest level since 2014.
Deficits are 'absolutely at the back of anybody's mind who's buying anything" other than the shortest-term Treasurys, said Priya Misra, a fixed income portfolio manager at J.P. Morgan Asset Management. 'You have to think about how much you want to get paid up for a fairly unsustainable debt trajectory."
Deficits are still not the biggest influence on yields, which are largely determined by economic data and investors' expectations for Fed policy. A run of mild inflation data has helped bring yields lower recently.
Investors also say that the Trump administration has ways it could mitigate the impact of deficits on the market. The most meaningful is its ability to lean more on ultrashort-term debt to meet coming borrowing needs, thereby minimizing pressure on longer-term bonds, which matter more for consumer and business borrowing costs.
The administration has strongly suggested it intends to do that by leaving the sizes of longer-term debt auctions unchanged at least through the end of the year. When it does come time to increase auction sizes, many analysts expect the Treasury Department to mostly focus on debt that matures in just two to seven years.
If demand is stronger for shorter-term bonds, it makes sense to 'just give the investors what they want," said Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets.
Write to Sam Goldfarb at [e-mail] and Justin Lahart at [e-mail]