Chart of the week: unsustainable fiscal policy – we might know it when we see it

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There was a flutter of excitement in government bond markets last week when US 30-year bond yields rose through 5%, a level not really seen since before the global financial crisis. The proximate cause was a weak auction for new US 20-year government bonds, where buyers demanded higher interest rates. But the bigger issue is US fiscal policy sustainability. The US administration’s proposed budget implies the federal deficit expanding to around 7% of GDP, a level previously only seen during WWII, the global financial crisis and briefly around the Covid pandemic. The expected deficit is coming during (a later stage of) an economic expansion, and when debt/GDP has already increased to 120%.

There is no specific set of rules that defines unsustainable fiscal policy, particularly as it relates to the biggest, most powerful economy and borrower in the world. But US Federal interest outlays have already increased to 3% of GDP, a level seen during the mid-1980s/1990s, when US debt-to-GDP was half the current level. Interest rates were obviously higher back then. So, the concern is that markets could demand higher interest rates to compensate for higher risk. This could force tighter fiscal policy on the US through spending cuts and/or higher tax rates, and force consumer and corporate borrowers to pay higher rates on loans, thereby putting downward pressure on spending, investment and real growth rates.

In practical terms, things may continue in their current direction for some time. And markets will have already factored in the details above. But there’s less room for error than before, and it does make many investment strategists and us somewhat cautious regarding US debt, especially long-term bonds and the US dollar.