US public debt concerns are growing in the higher interest rate regime

US credit rating downgrades highlight another effect of the rapid rise in interest rates: unease about the government's ability to maintain serviceable public finances in the long term. The US public debt-to-GDP ratio is at 94% and rising by more than 5% per year, enough to double the ratio within 13 years. Fiscal policies that support long-run growth and gradual fiscal consolidation can address this, but may be economically and politically challenging. We expect to see upside pressure and volatility on Treasury yields. 

• We share investor concerns regarding the long-run US fiscal trajectory, but do not anticipate a government debt crisis.
• We are optimistic on the US economy's long-run growth prospects, but as interest rates normalise it will be challenging to achieve debt sustainability without fiscal consolidation, in our view.
• Given insurers' role as long-term investors in fixed income securities, the expected higher bond yields for US treasuries can support investment returns. 

The US government's finances are in the spotlight for investors as higher interest rates are expected to put upward pressure on spending and debt issuance. Recent credit rating agency downgrades reflect this unease.¹ The pandemic spending bills that supported the economy also raised the public debt-to-GDP ratio to 94.2% in Q2 2023 from 77.6% four years ago (see Figure 1). This is a 5.6% annualised growth rate, against an historical rate of 2.5%. The US is not an outlier – public debt-to-GDP ratios are high in many advanced markets including Japan (261%), Italy (144%), France (112%) and Spain (112%).² However, the USD 1.7 trillion US primary deficit in the 2023 fiscal year cannot be reduced without drastic action such as major tax rises or spending cuts, either of which would likely trigger a recession. In the coming years, US debt issuance is expected to rise dramatically to cover growing spending needs and higher interest expenses.³ While there is no specific threshold at which a debt-to-GDP ratio becomes untenable, higher ratios constrain economic growth over time.⁴ We estimate that if the 5.6% annual growth rate in the US ratio were to continue, the ratio could double in less than 13 years (see Figure 2).

Figure 1: US publicly held debt-to-GDP ratio

Figure 2: US publicly held debt-to-GDP ratio, under different debt growth assumptions

We see pressure on government spending increasing due to structural factors as well as specific spending bills. The largest of the federal programmes, Social Security, is economically irreplaceable – four in 10 adults over age 65 would fall into poverty without monthly retirement benefits.⁵ Yet the latest social security trust fund projections imply a 20% revenue shortfall by 2034 without Congressional intervention as the number of retirees rises faster than the working population.⁶ In addition, after the rapid end in 2022 to the 30-year "Great Moderation" era of low interest rates, we expect positive real interest rates to pressure government debt obligations. With 30% of US government debt (USD 7.6 trillion) up for refinancing in the next 12 months, interest expenses are likely to consume an increasingly large share of the budget. ⁷

There are two channels by which to achieve long-term debt sustainability. The first is to narrow the differential between interest rates and economic growth. Stronger nominal GDP growth that outpaces long-term interest rates would allow the government to more quickly meet debt obligations. At present our long-run forecasts for US nominal GDP growth and the 10-year Treasury yield are equal at 4.2%. However, we see greater upside risks to interest rates than growth due to higher inflation volatility, reduced demand for Treasury bonds, and a smaller Fed balance sheet. Softer demand from foreign central banks and the Fed also places greater onus on domestic investors, driving rates even higher. Though a downside risk to economic growth, this may benefit insurers, who favor long-dated bonds. At the moment, US Treasuries represent 19% of P&C insurers' investment porfolios and 5% for life insurers.⁸

The second channel is fiscal consolidation to balance government revenue and spending more effectively. This is a key challenge for fiscal policymakers, who can be faced with unpalatable and politically unpopular choices over which taxes to raise or spending areas to cut. As the Peterson Institute outlines,⁹ the most feasible path of fiscal consolidation is gradual primary deficit reduction through higher revenues and lower outlays. However, this is a challenge given the electoral cycle and political polarisation.

A key safeguard for the US is the luxury of both reserve currency status and the world's deepest capital markets. For now, this affords it the flexibility to address debt concerns, as the US dollar remains the most reliable currency anchor of global capital markets. While this should alleviate near-term concern, the risks of global geopolitical fragmentation are higher today.¹⁰ For long-term bond investors such as insurers, we expect US debt affordability to be a recurring issue to monitor as it contributes to interest rate volatility.