As exciting as the stock market is to watch for many, the bigger story is unfolding in the bond market. Bonds have been thought of as this boring space where investors clip their coupons and benefit from their stability in times of market volatility.

However, the relationship of bonds being the ballast in a diversified portfolio is shifting due to a new inflationary regime of rising government debts and deficits driving interest rates higher.

Fiscal risk trends are deteriorating

The U.S. led the world in launching fiscal spending bazookas during the pandemic to support the private sector. This spending was at war-like levels and was possible by increasing the government’s budget deficit – ushering in the era of fiscal dominance, where government borrowing begins to drive the economy, crowd out the private sector, and makes monetary policy less potent. This fiscal dominance will gradually, but assuredly, push interest rates higher as borrowing levels increase and treasury buyers become leery. The world has awakened to the unsustainable nature of U.S. budget expenditures – most of which are non-discretionary such as Social Security, defense, Medicare and Medicaid.

It’s not a crisis yet – but we need to start focusing on the debt balance before it becomes a crisis. The U.S. is at the point where you realize that your credit card balance has become too big to keep spending at the current rate.

With interest rates well above the near-zero lows last seen in 2021 and higher projected deficits, there is an increasing amount of U.S. debt that needs to be rolled over at a higher interest rate. That is an unsustainable mix.

Inflation has been edging down; however, our view is that this decline is before the impact of tariff price increases and stubborn energy prices shows up in the data. Furthermore, while recession fears may push short-term rates lower, we believe that long-term rates may not come down as much proportionately due to concerns of the high deficits. The U.S. is looking at long-term secular rising interest rates. Something needs to give – such as a “Liz Truss” moment where bond yields jump on too much debt needing to be issued.

History and math show that there are few unappealing choices facing policy makers. We all live in a world of choices that are bound by constraints.

Some of us may recall from our Macro Econ 101 class on how policy makers can address high government debt and deficits using 4 options:

• defaulting,
• initiating austerity,
• grow the economy faster than the rate of debt growth, or
• decrease the real value of the debt through inflation/monetization.

While option 1, defaulting, is an extremely unlikely scenario, we feel that the more likely scenario is a combination of the remaining three options. While austerity is a low probability outcome at this stage, the chances of a mix of spending cuts and tax increases could rise if there is a tipping point or a bond market revolt such as a “Liz Truss” moment.

In viewing the U.S. levels of Inflation and Economic Growth as a quadrant, we believe we are in the top half of the Inflation and Economic Growth quadrant, but our Boom vs. Bust Economic Growth status will be dependent upon forthcoming productivity growth incentives.

The heavier emphasis will likely be on inflating our way out of the debt burden while trying to create incentives for productivity boosts. AI has the potential for pushing productivity higher and helping us grow out of the debt – akin to an individual increasing their income higher so that the debt level becomes manageable. But just as in our personal lives, it is easier said than done.

Factoring in these scenarios, we’re likely looking at benefit cuts, higher taxes, and higher inflation over the next several years as the U.S. addresses these unsustainable imbalances.

Facing reluctant buying of long bonds, the Treasury department will be forced to restart issuing short-term bills to meet the funding needs – a new set of buyers seems to be lining up through the increasing footprint of Stablecoin issuers alongside the existing money market funds.

If there is a wider economic air-pocket, then the Fed will likely step back in and restart QE (Quantitative Easing) as well as requiring banks to hold more treasuries on their balance sheets.

Large-scale issuance of short-term debt, politicizing the central bank and QE resembles policies often seen in emerging markets, which can weaken the currency and fuel inflation.