An Assessment of the U.S. debt and deficit

An Assessment of the U.S. debt and deficit

In December of 2017, the U.S. passed the Tax Cut and Jobs Act of 2017 which reduced corporate and individual tax rates. On March 23, 2018, an omnibus spending bill increased discretionary spending.  Declines in tax receipts and increased spending are expected to push the fiscal deficit higher.

The Congressional Budget Office (CBO) projects the federal debt to grow to 150% of GDP by 2047, a historic level.  Investors likely will grow increasingly worried about the long-term consequences of such significant debt levels. Additionally, growing fiscal deficits are occurring at the same time that the current account deficit has been widening, causing investors to contemplate the ramifications of “twin deficits” and raising questions such as where will the money come from? And what might investors do to prepare? While a good deal of uncertainty remains, looking back at the past allows some light to be shed on these questions.

Despite debt breaching historic levels, theory and history suggest Treasury rates will remain constrained by growth rates and inflation. Ultimately, Treasury yields are likely to be more reflective of policy rates rather than pure supply and demand dynamics. The source of funding of the debt, however, likely will impact economic fundamentals and financial markets over the long run.  Foreign investment likely will continue to serve as a material source of funding, making a reduction in the trade deficit difficult.

In this article, we briefly explore the implications for interest rates, funding options available to finance the federal debt and the implication of high debt levels on capital markets going forward. Our conclusions include the following:

  • Long-term fiscal imbalances will need to be addressed in order for economic growth to strengthen; however, the impact on capital markets seems to be modest at this point due to the fact that the U.S. is viewed as a traditional safe haven for global investors.
  • The unique strength of the U.S. economy and the global market’s appetite for the U.S. dollar should blunt any deterioration in the U.S. government’s credit standing, therefore limiting a significant increase in debt servicing costs.
  • The implications on various highlighted asset classes would not cause us to consider altering investor long-term strategic allocations.
  • The current conditions may give rise to tactical opportunities moving forward (e.g., a temporary interest rate spike). However, it is our assessment that, at the present time, no such obvious opportunities exist.

While history may not repeat, we believe it is likely to rhyme and investors should prepare accordingly.

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Inquiries or comments concerning this article may be addressed to:
Robert Lee, Ph.D.
Research Director, Risk Management and Strategic Analysis
Pavilion Advisory Group Inc.

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