America may soon be spending more on debt service than defence

THE BOND market is sending a hopeful message about the strength of the American economy—and, perhaps, raising alarm about America’s unsustainable finances. The news is coming via surging rates on long-term bonds. When the Federal Reserve started raising its benchmark federal-funds rate in March 2022, long-term interest rates rose with it. This continued fairly steadily until the end of last year, when rates flattened out. Then in May, to the surprise of many investors, long-term rates began climbing once more. They show no sign of slowing. On October 11th the yield on ten-year Treasury bonds hit 4.7%, near a 16-year high.

Because bond prices and yields are inversely related, this is bad for bond investors, who are suffering “the greatest bond bear market of all time”, according to Bank of America. But it is also bad for Uncle Sam. When bond yields rise, the cost of financing America’s debt—now $26trn and growing—also goes up. In the fiscal year ending on September 30th 2023, interest payments on America’s debt totalled some $660bn, up from $475bn the previous year. As recently as May 2022 the Congressional Budget Office (CBO), a non-partisan number-cruncher, had forecast such costs would be $442bn, or 33% lower.

This would not be such a problem if America were putting its fiscal house in order. But estimates released on October 10th by the CBO show that the federal deficit ballooned to $2trn (7.6% of GDP) in the year to September 30th, up from $900bn (3.5%) the previous year. If interest rates and deficits do not come down, fiscal hawks warn, the cost of servicing America’s debt could rocket, crowding out other spending. The CBO estimates that, even assuming a drop in rates, interest costs by 2028 will reach $1trn, or 3.1% of projected GDP—more than will be spent on defence.

Such figures should frighten policymakers in Washington. Even on a benign reading of the reason why interest rates have resumed rising—that the chances of imminent recession have fallen, causing the Fed to keep its benchmark higher for longer—interest payments as a share of GDP are likely to keep rising because of the widening deficit, despite the better prospects for growth. And on a less benign reading—that rising rates reflect fear about the scale of issuance of Treasury debt issuance and lack of appetite for such securities—there is all the more reason to worry.

Whatever the reason, equity investors see a silver lining. On October 9th, in remarks to the National Association for Business Economics, a trade association, Lorie Logan, president of the Dallas Fed, said that about half of the increase in long-term rates since July reflects a rise in the “term premium”, the extra return that investors demand to compensate them for locking up their money for longer periods. If long-term interest rates remain high, Ms Logan explained, further Fed tightening later this year may not be necessary. Shares promptly jumped. The stockmarket’s concerns about America’s fiscal health, at least, will wait for another day.■