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.
February 6, 2025
By Atul Bhatia, CFA
The U.S. economy has shown unexpected resilience during the post-pandemic era, confounding both U.S. Federal Reserve and private sector forecasters. One of the key factors, we believe, has been the expanding federal budget deficit. The growth in debt-funded government spending contributed to demand, helping push up household wages, corporate profits, and ultimately asset prices.
The deficit, we believe, provided a fillip to the economy as it recovered, but we are increasingly concerned with the magnitude of the government’s shortfall. At 6.5 percent of GDP, we are in uncharted territory for the modern U.S. economy: it’s the first time the government has run a deficit this large outside of a recession. This is, in our view, a risky evolution of fiscal policy.
We should make clear at the outset that we are not concerned with the federal debt. As we have discussed many times in the past, we think U.S. default fears are wildly overblown, and that the U.S. is rich in public and private sector assets and productive capacity.
But the deficit is different, and from our vantage point, it’s troubling on two fronts.
First and foremost is the potential for unsustainably fast growth putting pressure on inflation. The logic is simple: the U.S. economy is firing on all cylinders, with high wages and investment returns fueling household consumption and artificial intelligence opportunities propelling corporate investment. The additional boost from federal deficit spending adds to the demand.
What’s less simple is identifying slack to meet that demand. Unemployment is hovering around four percent, a full percentage point below its long-term median, and while technology promises greater productivity, that’s unlikely to be helpful over the next two quarters. Trade has often filled the domestic supply void, but that may be less available this time around given the potential for tariffs and higher scrutiny at border crossings. The result seems to be potential upward pressure on prices.
The second deficit-linked concern for investors is the amount of upcoming bond supply. Markets, we believe, are certainly capable of absorbing U.S. Treasury bond issuance – Treasuries remain the deepest, most liquid security type in the world. But pushing out trillions of dollars in bonds in less than 12 months risks straining investor appetite and balance sheet capacity.
This backdrop gives two reasons for longer-term U.S. interest rates to stay elevated relative to the low interest rate environment of the past decade, in our opinion. Fast growth and inflation make equities and other growth-sensitive assets attractive compared to fixed coupons. And large supply means that borrowers – including the government – may need to pay higher coupons to attract buyers.
But high rates – like those high prices in the aforementioned adage – tend to be self-correcting.
The shift can come in two ways.
The first is a slowdown in the private sector that offsets the government’s expansionary policies. To some extent, this is already happening. We’ve seen multiple corporate issuers pull billions in bond deals last month because rates were too high. At the margin, missed bond sales mean fewer investments and slower expansionary hiring.
Historically, it’s been the federal deficit that has reacted to shifts in private sector activity, but there’s nothing to say the dynamic cannot work in reverse and we may be witnessing the early stages of that shift.
The other alternative is that neither the government nor the private sector blink, and growth continues at its current pace. If that proves inflationary, as seems possible to us, the Fed would be forced to respond, raising short-term interest rates to engineer a growth slowdown.
Our view is that we’re likely to see most of the work done by the private sector adjusting to higher rates. On the Fed, we think an actual rate hike is unlikely, and that – at most – we could see investors shift their rate cut expectations to later in the year.
To be fair, there is a third path forward: the federal government could move toward a more balanced budget. While there are efforts in this direction – most notably by the Elon Musk-led team known as the Department of Government Efficiency, or DOGE – we see significant political hurdles to rapidly implementing large fiscal retrenchment. People simply like to receive federal benefits and dislike paying higher taxes.
Even though we see the risk of higher rates and the potential for slower economic growth as a result, we do not think the answer is for investors to head for the sidelines. To begin with, we are talking about fundamentally healthy adjustments that the economy always undergoes – and that it needs to undergo, in our view.
In addition, at current yield levels, coupon income from government securities provides a meaningful cushion against potential yield curve shifts. The table below lays out estimated returns for Treasury bond investors over a 12-month time horizon under various scenarios. While marked-to-market losses are easily conceivable, we believe the cash flow from coupons likely makes them manageable for most investors under a range of assumptions.
* For example, if the bond’s 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%.
Source – RBC Wealth Management, Bloomberg
Finally, the world is a dangerous and uncertain place. Although we can map out a reasonable scenario of steady growth and a drift higher in interest rates, all but the youngest of investors can remember shocks to the system from COVID to regional bank scares and the global financial crisis. Holding a diversified portfolio of assets is a time-tested approach to dealing with unexpected event risk or the next appearance of a recession or growth slowdown.
Our message isn’t to be scared; it’s to not be euphoric and extend the current robust growth framework to infinity and beyond.
We want to talk about your financial future.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. Deposits made with Royal Bank of Canada (Channel Islands) Limited in Jersey are not covered by the UK Financial Services Compensation Scheme. Royal Bank of Canada (Channel Islands) Limited is a participant in the Jersey Bank Depositors Compensation Scheme. The Scheme offers protection for ‘eligible deposits’ up to £50,000 per individual claimant, subject to certain limitations. The maximum total amount of compensation is capped at £100,000,000 in any 5 year period. Full details of the Scheme and banking groups covered are available on the Government of Jersey’s website www.gov.je/dcs or on request.