In brief

• The U.S. debt to GDP ratio trajectory has shifted materially higher in the past few years, but markets have remained unnerved until recently, where we saw a rise in yields after the elections.
• Strong structural demand for the U.S. Dollar and U.S. Treasuries, supported by strong institutional frameworks and investor confidence, have facilitated the orderly absorption of increased Treasury supply.
• While any near-term fiscal crisis is unlikely, the long-term need to balance fiscal policy and debt sustainability could potentially lead to higher yields and bond market volatility. Investors should consider diversifying their duration exposure and explore alternatives like real assets and hedge funds to mitigate such risks.

The recent Republican sweep of Congress has reignited concerns over the U.S. debt profile and direction of long-term yields. Three key data points illustrate why:

• Under President-elect Trump’s fiscal plans, the government is projected to raise only 61 cents for every dollar spent, according to estimates by the Committee for a Responsible Federal Budget (CFRB).
• The current U.S. deficit stands at 6.4% of gross domestic product (GDP)—a level only seen during World War II (WWII), the Great Financial Crisis (GFC) and the pandemic—at a time when the U.S. economy is already operating at full employment.
• As shown in Exhibit 1, U.S. debt-to-GDP is estimated to rise from 99% currently to a record-breaking 132% in 10 years if the expiring tax cuts are extended (surpassing WWII levels) , and 143% if other proposed tax cuts are implemented. These forecasts by the Congressional Budget Office (CBO) and CFRB are arguably conservative, as they do not account for the potential of a severe recession or financial crisis, which could further increase fiscal deficits. Neither are they adjusted for a potential spike in inflation from the fiscal policy and rise in yields, which could increase interest outlays.
   

Exhibit 1: Federal net debt (accumulated deficits)
% of GDP, 1940-2034, CBO Baseline Forecast, end of fiscal year

Source: CBO, J.P. Morgan Asset Management. (Left) Treasury department. Estimates are from the Congressional Budget Office (CBO) June 2024. An Update to the Budget Outlook: 2024 to 2034. *Adjusted by JPMAM to include estimates from the CBO May 2024 report “Budgetary Outcomes Under Alternative Assumptions About Spending and Revenues” on the extension of Tax Cuts and Jobs Act (TCJA) provisions. Data reflect most recently available as of 12/11/24.

Despite such risks, markets have remained relatively calm, even during Fitch’s U.S. Treasury (UST) rating downgrade and past debt ceiling debates. However, recently, 10-year UST rose ~80 basis points (bps) since mid-September despite the Federal Reserve (Fed) cutting by 75 bps, likely due to fiscal fears and potentially inflationary policy. How worried should we be?

Few near term signs of panic

Despite the ballooning debt, markets are not pricing in significant risks yet.

• There has not been a surge in inflation expectations. 1-year inflation expectations remain stable at 2.4% in November, and the latest 5-year and 10-year breakeven inflation rates are also roughly in the same range.
• More importantly, the bond market has an important role of policing policymakers, and yields have not spiked dramatically. In fact, despite a ~60 percentage point increase in the debt-to-GDP ratio over the past 20 years, 10-year Treasury yields have remained stable. Since the start of FY2023, the Treasury has borrowed close to USD 5trillion additionally, yet the 10-year yield has only increased modestly.

So why does the U.S. have the ability to issue more debt without jeopardizing its financial position or economic stability, or as the International Monetary Fund describes, have significantly more “fiscal space” than other countries?

A key factor is investors’ confidence in the U.S. government’s ability and willingness to honor its debt, making it one of the safest and most liquid investments due to its creditworthiness. This confidence stems from a strong and stable institutional framework, monetary policy flexibility, a stable currency and a large and diversified economic base.

This reputation has created strong structural demand for U.S. Treasuries (USTs). To start, it is the primary reserve currency for central banks globally. Foreign ownership of USTs has increased rapidly from ~20% in 1990 to a peak of ~60% in 2007. However, this has recently retreated to ~40%, replaced by increased demand from banks and asset managers. For these institutions, apart from an income-generating investment, USTs also serve as high-quality collateral, an asset-liability management tool and as a portfolio diversifier. Under post-GFC regulations, the holding requirements for USTs have also increased for various financial institutions. The indispensable role of USTs in the global and domestic financial system continues to support their market stability.

Indeed, there are several risk factors, such as a slow pace of central banks’ foreign reserve accumulation, a falling share of the U.S. dollar in those reserves, and a gradual shift in investor demand towards more price-sensitive buyers such as households and corporates. However, none of these are near-term threats, and USTs will likely continue their crucial role in the financial system, supporting UST’s market stability.

So when will it become a problem?

A debt crisis could occur if U.S. debt levels rise to an unsustainable level. Various institutions have attempted to assess this threshold, with the Penn Wharton Budget model estimating it to be 175-200% of GDP. While this involves multiple assumptions on highly uncertain variables, the U.S. is unlikely to breach such levels in the near or medium term, according to current CBO forecasts.

A crisis could also be triggered by one or more of the following:

• a sharp spike in inflation and thus interest rates
• a severe recession or financial crisis
• a loss of confidence in U.S. institutions

In other words, if the gap between growth and interest rate does not worsen materially, or the growth rate of GDP outpaces the growth in debt, fiscal risks should be contained. The 2022 UK gilt market volatility highlighted the importance of the market’s trust in government institutions and central bank independence. In the U.S., the Fed has earned such credibility. For example, in March 2020, the Fed stepped in swiftly to provide an emergency-lending backstop to prevent a liquidity crisis. In fact, that willingness and commitment mattered more in restoring confidence, than the actual amount lent.

While the Fed can be the lender of last resort and “buy time” to prevent a near-term crisis, in the long-term, the U.S. government will need to tighten fiscal measures. One way is through raising taxes, which is unlikely in the next four years. This strategy will also slow growth and potentially reduce overall tax revenue. Alternatively, spending can be cut. However, as seen in Exhibit 2, discretionary spending as a % of GDP is projected to decrease, with factors such as an aging population and higher interest rates continually increasing the need for mandatory spending and interest outlays.

Exhibit 2: Fiscal outlays as a % of GDP
CBO Baseline Forecast

Source: CBO, J.P. Morgan Asset Management. Federal Reserve, FRED. Mandatory spending is spending that is required by law and does not require an annual vote by Congress. Examples include Medicare and Social Security, which continue to operate automatically unless Congress changes the law. Discretionary spending is spending that requires an annual vote by Congress through an appropriations bill. Examples include defense, education, transportation and certain health spending. Data reflect most recently available as of 12/11/24.

The longer the adjustment is delayed, the more painful the necessary austerity will eventually be to keep debt sustainable.

Investment implications

Despite high U.S. debt levels, dollar dominance and trust in U.S. institutions are likely to continue supporting structural demand for UST, and there are no likely triggers of a fiscal crisis in the near to medium term.

However, this does not mean it doesn’t matter for investors now, as long-term risks do affect markets. An ongoing increase in fiscal deficit could lead to higher long-term UST yields through two channels: 1) higher expected policy rates in the future, and 2) higher term premia (due to higher long-term risk of default, higher inflation volatility, and investors demanding higher compensation given higher Treasury supply).

In fact, our 2025 Long-term Capital Market Assumptions increased the term premia, steepening the U.S. yield curve.

What does this mean for asset allocation? Given the bond market’s role as an “economic policeman” of fiscal decisions, fiscal activism combined with higher deficits may keep Treasury volatility high.

Given the role of core bonds to lower portfolio volatility, as well as the long-term risks associated with rising U.S. debt, investors should diversify their duration exposures beyond the U.S. Moreover, alternatives, such as real assets and hedge funds, can also help hedge against bond volatility and inflation, and hold up value better than other assets in the unlikely case of a debt crisis.

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