Russell Price, Sr. Economist, Ameriprise Financial
- Rising interest rates and signs of inflation have contributed to market volatility this year
- Higher interest rates will make financing the federal debt more expensive for taxpayers
- Fixed income portfolios may experience some pressure in this environment
Rising interest rates have contributed to the volatility we’ve seen in financial markets this year. The yield on the benchmark 10-year Treasury note ended 2017 near 2.4%. Through February and March of this year the Treasury note yield was above 2.8%, and by year-end the rate could approach the 3% level for the first time since 2013. Interest rates have long been expected to move higher as the economy improved, but signs of brewing inflation and growing government debt have accelerated the run-up in rates beyond what many anticipated.
Recent tax cut legislation will add approximately $1.5 trillion to the total federal debt over the next 10 years.
Increased government borrowing
Tax cuts passed at the end of December under the Tax Cuts and Jobs Act will add approximately $1.5 trillion to the total federal debt over the next ten years, according to an analysis released by the Congressional Budget Office (CBO) in January. Federal spending will also increase by $300 billion over the next two-years, under a bipartisan budget deal reached in January.
Higher rates are expected
A consideration with the government debt outlook is that the CBO has long factored in higher interest costs in making their projections. In fact, over the last few years CBO projections have over-estimated interest costs in comparison to the actual interest incurred.
As of its most recent long-term projection report in June 2017, the CBO assumed an average 10-year Treasury rate of 3.0% for 2018, a level we have yet to reach. It also assumes an average 10-year Treasury yield of 3.4% for 2019 and 3.5% for 2020, after which it assumes a rate of 3.7%.
These actions are projected to push the federal budget deficit for fiscal year 2019 to nearly $1 trillion. The CBO has not yet released updated debt and deficit projections to reflect these changes, but financial markets are already showing concern for the greater borrowing needs by driving interest rates higher.
As rates rise, the government incurs higher financing costs on the nation’s debt, making the challenge of managing the federal debt problem that much more difficult. Recent actions to cut taxes and increase government spending will increase government debt projections, thus amplifying interest rate concerns.
Estimates indicate that the U.S. government debt may rise to 100% of economic activity, as measured by gross domestic product (GDP), by 2032.
Economics of the federal budget deficit
At the end of February, total federal government debt outstanding and held by the public was $15.2 trillion, according to the U.S. Treasury Department. This was equivalent to about 77% of the underlying economy. In its most recent long-term outlook, the CBO projected U.S. government debt would rise to 100% of economic activity by 2032. However, this does not account for the recent tax cuts and increase in government spending, which means we would reach this level sooner once the CBO updates its outlook.
Stronger economic growth could generate more tax revenue and thus delay the point at which debt levels become problematic. At some point over the next 10 to 15 years, elected officials must make changes that “bend the curve” in relation to long-term debt projections and put government finances on a healthier path. That most likely means tax increases, spending cuts or a combination of the two.
What does this mean for investors?
We believe interest rates could see further upward pressure over the intermediate-term, yet the pace of increase should be modest. However, rising rates are likely to put pressure on fixed income portfolios (given that bond prices fall as interest rates rise), but there are strategies investors can employ to cushion the impact. Additionally, higher rates should eventually enable fixed income investors to generate a higher level of income from their portfolios.
Talk to your financial advisor to help determine how to position your portfolio in this changing environment based on your investment goals.