{"id":27146,"date":"2025-02-07T10:02:42","date_gmt":"2025-02-07T15:02:42","guid":{"rendered":"https:\/\/www.rbcwealthmanagement.com\/en-ca\/?p=27146"},"modified":"2025-02-07T10:13:24","modified_gmt":"2025-02-07T15:13:24","slug":"the-us-deficit-interest-rates-and-private-sector-interplay","status":"publish","type":"post","link":"https:\/\/www.rbcwealthmanagement.com\/en-ca\/insights\/the-us-deficit-interest-rates-and-private-sector-interplay","title":{"rendered":"The U.S. deficit, interest rates, and private sector interplay"},"content":{"rendered":"\n

By Atul Bhatia, CFA<\/strong><\/p>\n\n\n\n

U.S. growth is solid, but perhaps not stable<\/h2>\n

\n The U.S. economy has shown unexpected resilience during the post-pandemic\n era, confounding both U.S. Federal Reserve and private sector forecasters.\n One of the key factors, we believe, has been the expanding federal budget\n deficit. The growth in debt-funded government spending contributed to\n demand, helping push up household wages, corporate profits, and ultimately\n asset prices.\n <\/p>\n

\n The deficit, we believe, provided a fillip to the economy as it recovered,\n but we are increasingly concerned with the magnitude of the government\u2019s\n shortfall. At 6.5 percent of GDP, we are in uncharted territory for the\n modern U.S. economy: it\u2019s the first time the government has run a deficit\n this large outside of a recession. This is, in our view, a risky evolution\n of fiscal policy.\n <\/p>\n

\n We should make clear at the outset that we are not concerned with the\n federal debt. As we have discussed many times in the past, we think U.S.\n default fears are wildly overblown, and that the U.S. is rich in public\n and private sector assets and productive capacity.\n <\/p>\n \n

Deficit implications a dual threat<\/h2>\n

\n But the deficit is different, and from our vantage point, it\u2019s troubling\n on two fronts.\n <\/p>\n

\n First and foremost is the potential for unsustainably fast growth putting\n pressure on inflation. The logic is simple: the U.S. economy is firing on\n all cylinders, with high wages and investment returns fueling household\n consumption and artificial intelligence opportunities propelling corporate\n investment. The additional boost from federal deficit spending adds to the\n demand.\n <\/p>\n

\n What\u2019s less simple is identifying slack to meet that demand. Unemployment\n is hovering around four percent, a full percentage point below its\n long-term median, and while technology promises greater productivity,\n that\u2019s unlikely to be helpful over the next two quarters. Trade has often\n filled the domestic supply void, but that may be less available this time\n around given the potential for tariffs and higher scrutiny at border\n crossings. The result seems to be potential upward pressure on prices.\n <\/p>\n

\n The second deficit-linked concern for investors is the amount of upcoming\n bond supply. Markets, we believe, are certainly capable of absorbing U.S.\n Treasury bond issuance\u2014Treasuries remain the deepest, most liquid security\n type in the world. But pushing out trillions of dollars in bonds in less\n than 12 months risks straining investor appetite and balance sheet\n capacity.\n <\/p>\n \n

Higher rates are a brake, but can be applied differently<\/h2>\n

\n This backdrop gives two reasons for longer-term U.S. interest rates to\n stay elevated relative to the low interest rate environment of the past\n decade, in our opinion. Fast growth and inflation make equities and other\n growth-sensitive assets attractive compared to fixed coupons. And large\n supply means that borrowers\u2014including the government\u2014may need to pay\n higher coupons to attract buyers.\n <\/p>\n

\n But high rates\u2014like those high prices in the aforementioned adage\u2014tend to\n be self-correcting.\n <\/p>\n

The shift can come in two ways.<\/p>\n

\n The first is a slowdown in the private sector that offsets the\n government\u2019s expansionary policies. To some extent, this is already\n happening. We\u2019ve seen multiple corporate issuers pull billions in bond\n deals last month because rates were too high. At the margin, missed bond\n sales mean fewer investments and slower expansionary hiring.\n <\/p>\n

\n Historically, it\u2019s been the federal deficit that has reacted to shifts in\n private sector activity, but there\u2019s nothing to say the dynamic cannot\n work in reverse and we may be witnessing the early stages of that shift.\n <\/p>\n

\n The other alternative is that neither the government nor the private\n sector blink, and growth continues at its current pace. If that proves\n inflationary, as seems possible to us, the Fed would be forced to respond,\n raising short-term interest rates to engineer a growth slowdown.\n <\/p>\n

\n Our view is that we\u2019re likely to see most of the work done by the private\n sector adjusting to higher rates. On the Fed, we think an actual rate hike\n is unlikely, and that\u2014at most\u2014we could see investors shift their rate cut\n expectations to later in the year.\n <\/p>\n

\n To be fair, there is a third path forward: the federal government could\n move toward a more balanced budget. While there are efforts in this\n direction\u2014most notably by the Elon Musk-led team known as the Department\n of Government Efficiency, or DOGE\u2014we see significant political hurdles to\n rapidly implementing large fiscal retrenchment. People simply like to\n receive federal benefits and dislike paying higher taxes.\n <\/p>\n \n

Economic uncertainty shouldn\u2019t mean investing paralysis<\/h2>\n

\n Even though we see the risk of higher rates and the potential for slower\n economic growth as a result, we do not think the answer is for investors\n to head for the sidelines. To begin with, we are talking about\n fundamentally healthy adjustments that the economy always undergoes\u2014and\n that it needs to undergo, in our view.\n <\/p>\n

\n In addition, at current yield levels, coupon income from government\n securities provides a meaningful cushion against potential yield curve\n shifts. The table below lays out estimated returns for Treasury bond\n investors over a 12-month time horizon under various scenarios. While\n marked-to-market losses are easily conceivable, we believe the cash flow\n from coupons likely makes them manageable for most investors under a range\n of assumptions.\n <\/p>\n \n

\n Return potential for a 4.50% 10-year Treasury under various yield\n scenarios\n <\/h3>\n
\n \n \n \n \n Assumed future yield*<\/th>\n Expected price move<\/th>\n Coupon income<\/th>\n Total return<\/th>\n <\/tr>\n <\/thead>\n \n \n 3.0%<\/td>\n 11.78%<\/td>\n 4.50%<\/td>\n 16.28%<\/td>\n <\/tr>\n \n 3.5%<\/td>\n 7.85%<\/td>\n 4.50%<\/td>\n 12.35%<\/td>\n <\/tr>\n \n 4.0%<\/td>\n 3.93%<\/td>\n 4.50%<\/td>\n 8.43%<\/td>\n <\/tr>\n \n 4.5%<\/td>\n 0.00%<\/td>\n 4.50%<\/td>\n 4.50%<\/td>\n <\/tr>\n \n 5.0%<\/td>\n -3.93%<\/td>\n 4.50%<\/td>\n 0.57%<\/td>\n <\/tr>\n \n 5.5%<\/td>\n -7.85%<\/td>\n 4.50%<\/td>\n -3.35%<\/td>\n <\/tr>\n \n 6.0%<\/td>\n -11.78%<\/td>\n 4.50%<\/td>\n -7.28%<\/td>\n <\/tr>\n <\/tbody>\n <\/table>\n <\/div>\n

\n *\u2009For example, if the bond\u2019s yield drops to 4% 12 months from now, we would expect its price to rise approximately 3.9%. Considering the 4.5% coupon income received during the year, the investor would have a total marked-to-market gain of 8.4%.\n <\/p>\n

Source – RBC Wealth Management, Bloomberg<\/p>\n \n

\n Finally, the world is a dangerous and uncertain place. Although we can map\n out a reasonable scenario of steady growth and a drift higher in interest\n rates, all but the youngest of investors can remember shocks to the system\n from COVID to regional bank scares and the global financial crisis.\n Holding a diversified portfolio of assets is a time-tested approach to\n dealing with unexpected event risk or the next appearance of a recession\n or growth slowdown.\n <\/p>\n

\n Our message isn\u2019t to be scared; it\u2019s to not be euphoric and extend the\n current robust growth framework to infinity and beyond.\n <\/p>\n","protected":false},"excerpt":{"rendered":"

Economics is rife with self-correcting mechanisms, and we give our thoughts on how that dynamic is likely to play out in the relationship between the U.S. budget deficit and longer-term interest rates.<\/p>\n","protected":false},"author":15,"featured_media":27150,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"rbcwm_post_date":"2025-02-06T16:35:53","editor_notices":[],"rbc_url_alias":"","rbcwm_featured_desktop_image_position":"","rbcwm_featured_mobile_image_position":"","_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[73],"tags":[792,256,793],"rbcwm_content_owner":[607],"rbcwm_need":[],"rbcwm_segment":[],"rbcwm_solution":[],"rbcwm_topic":[74],"rbcwm_channel":[],"rbcwm_format":[],"class_list":["post-27146","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-analysis","tag-deficit","tag-federal-reserve","tag-treasury-bonds","rbcwm_content_owner-pag","rbcwm_topic-global-insights"],"acf":{"rbcwm_subtitle":"Economics is rife with self-correcting mechanisms, and we give our thoughts on how that dynamic is likely to play out in the 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