Every January, firms throughout the financial industry, including our own, hold annual training meetings or conferences. One of the highlights of these meetings is an award for salesperson or sales team of the year. These titles are hard-earned and well-deserved. At least for our own firm, I can say that the winners are always those who, not only achieve impressive revenues for the firm, but do so through very hard work, understanding the investment environment and, most of all, understanding the needs of our clients.

But with all due respect to my colleagues, no one in 2023 had a sales year that came anywhere close to that of Janet Yellen and her minions over at the Treasury Department.

Last year, they achieved net sales of Treasury debt of $1.86 trillion—the second highest total ever. This allowed them to not only finance a massive federal budget deficit but also to stash an additional $360 billion into their checking account at the Fed.

Moreover, they did this in the face of still high inflation, the rising expense of foreign conflicts, threats of government shutdown and default and being put on a ratings agency downgrade watchlist. In addition, despite aggressive Fed tightening and a lot of volatility during the year, they were able to finance their long-term debt at essentially the same rates at the end of the year as at its start. And, remarkably, they achieved all of this while their biggest customer was redeeming their bonds at a pace that would rival the “returns” line in Costco on the day after Christmas. Indeed, their net sales to U.S. and international investors, outside of the Federal Reserve, amounted to $2.56 trillion, up 63% from a year earlier and 22% higher than the previous record set in the pandemic year of 2020.

Rising Debt Worries And Offsets
All of this, of course, says more about the appetite of global investors for U.S. Treasuries, that it does about the marketing skill of the Treasury Department. And this demand should, to some extent, calm fears that rising federal debt will soon lead to surging long-term interest rates. 

Clearly, there are reasons for concern about rising federal debt. In their 10-year projections last May, the Congressional Budget Office, or CBO, estimated that annual deficits would climb from $1.4 trillion in fiscal 2022 to $2.2 trillion in fiscal 2033, with the debt-to-GDP ratio rising from 97% to a record 119% over the same period. Importantly, however, these forecasts included a significant underestimate of the 2023 budget deficit and also, by convention, assumed that the 2017 tax cuts would not be extended beyond 2025.

If we adjust these forecasts for the part of the CBO forecast error that is likely to persist and we assume that the 2017 tax cuts are, in fact, extended, the math gets even more worrying, with federal debt in the hands of the public on track to reach $50 trillion by 2033 or 127% of GDP.

However, even on this sobering path, there are important offsets that could limit any increase in long-term interest rates, at least in the near term.

First, even if the economy continues to grow over the next few years, the Federal Reserve will have to wrap up its quantitative tightening program in order to allow its “ample reserves” regime to continue to operate. Since the Fed is currently reducing its Treasury holdings by up to $720 billion per year, this would significantly reduce the government’s need to borrow from other investors. If the economy were to fall into recession, the Fed might resume its quantitative easing program, further reducing Treasury’s need to borrow in the open market, although a recession would obviously strain the budget in other ways.

Second, primarily because of Fed tightening, net interest costs for the federal government have soared from $350 billion in fiscal 2021 to $660 billion in fiscal 2023 and likely close to $900 billion this year. Aggressive Fed rate cuts, in the face of recession or even persistently low inflation, could reduce this cost very substantially.

Third, the U.S. Treasury raises money in a global market for government bonds. Even as the United States faces a rising debt-to-GDP ratio in the years ahead, other governments may be more frugal and thus reduce the strain on markets from U.S. borrowing. In particular, in its October 2023 World Economic Outlook, the International Monetary Fund estimated that the net government debt of the Euro Zone, the U.K. and Japan would all fall as a percentage of GDP between 2023 and 2028.

The Cost Of Not Fixing The Debt
All of this reduces the risk that long-term interest rates will spike higher because of the federal government’s borrowing needs. However, it is hardly a cause for celebration or complacency. The reality is that all of this rests on an assumption of attaining and maintaining low inflation and a strong dollar. Without low inflation, the Federal Reserve will likely keep QT going for longer and resist calls for reductions in short-term interest rates. If the dollar were to fall sharply, both U.S. and international investors would likely demand a premium to invest in U.S. securities rather than accepting a discount. 

The problem is, the low inflation achieved between the 1980s and the start of this decade was facilitated in part by rising inequality which tended to boost the demand for financial assets and homes and limit the demand for basic goods and services. The strong dollar, so important to global demand for our stocks and bonds, has cost millions of manufacturing jobs and left the United States with a permanent trade deficit, adding annually to our foreign obligations.

It is a sad predicament when our ability to finance our government debt hinges on our willingness to maintain yawning inequality today and reduce our prospective standard of living in the years to come. Moreover, to state the obvious, chronically high budget deficits reduce our ability to respond to geopolitical issues, domestic disasters or recessions.

Investment Implications
Rising interest payments have been the biggest reason for a sharp increase in the budget deficit recently. However, any attempt to reduce the deficit in the long run would have to come from reducing the primary deficit—that is the gap between non-interest spending and revenues. This, in turn, requires voters to be willing to elect politicians who promise to do unpopular things. The usual whipping boy of those who pretend to be deficit hawks, is discretionary, non-defense spending. However, as we show on page 20 of the Guide to the Markets, this broad basket of government services only accounted for 15% of federal spending last year. Indeed, even a cursory glance at the federal finances makes it clear that any attempt to achieve balance would have to rein in spending on Defense, Medicare, Medicaid and Social Security while raising taxes.

There is no evidence that voters are ready for this. And so, most likely, the deficit and debt will continue to worsen, gradually adding to the underlying level of real interest rates.

For investors, this suggests three broad implications. First, the debt-to-GDP ratio will continue to rise for many years to come. However, this should merely put some upward pressure on long-term interest rates—there is no reason to believe that it is about to trigger a short-term financial crisis.

Second, in the medium term, budgetary pressures will likely require some increase in taxes and some cuts in spending. Taxes will likely be raised on the rich while spending growth will likely be curtailed for older Americans. If you are richer and older than average, the government will likely tax you more and spend on you less, making it even more important to build a bigger private nest egg.

Finally, as with any risk, it is important to consider how to mitigate it. Surging levels of government debt, combined with a high exchange rate, are more of a problem in the United States than in, for example, the Euro Zone. For those worried about a U.S. debt meltdown, the most obvious way to reduce risk is invest more around the world. This should be good protection if someday, the sales force in the Treasury department, finds themselves with a product they just can’t sell at any reasonable price.

David Kelly is chief global strategist at J.P. Morgan Asset Management.