US bond market on the precipice when it comes to funding the deficit

In cash terms, the US fiscal deficit is running at around $2tr. Of this, about half is net interest and the other half is the primary deficit. On top of that, debt redemptions run at around $2tr, which translates into an annual re-funding requirement of a little more than $4tr. That breaks down to a quarterly re-funding of US$1tr. That was running at around $0.4tr in the fourth quarter of 2016 when Donald Trump was first elected president, when the deficit was running at some 3% of GDP (versus 6%+ now).

Looking ahead to 2025, it remains to be seen whether there is material success in cutting discretionary spending. This is currently running at around 6% of GDP. In fact, it’s around the same level as the fiscal deficit itself. It’s important that discretionary spending as a percentage of GDP gets cut in the years ahead as compensation for the rise in interest payments. The Congressional Budget Office projects that interest spending rises from 3% of GDP today to 4% of GDP in the coming decade. Discretionary spending must fall as an offset.

Even as discretionary spending falls as a percentage of GDP to offset the rise in interest rate spending, it won’t be enough to cut the fiscal deficit, unless some material action is taken. The tax cuts executed during the first Trump presidency were advertised as self-financing but weren’t. There is nothing to suggest that projected tax cuts this time around will be any different. And the jury is out on the extent to which tariffs can bring in material revenue income. And if nothing changes, the debt/GDP ratio keeps rising.

These are issues the Treasury market must grapple with as we progress through 2025. And indeed into 2026 as tax cuts that get through the legislative process will take effect from January 2026 onwards. Meanwhile, the rising fiscal deficit continues to increase the supply of Treasuries in the market. This is occurring alongside the Federal Reserve’s quantitative tightening, which has already reintroduced approximately $2tr worth of Treasuries into the market.

The main impact of this fiscal pressure has been to cheapen Treasury yields relative to SOFR rates. For example, in the 10yr tenor, the spread from the SOFR rate to the Treasury yield is now about 50bp. That was averaging around 25bp through to the middle of 2023. Since then, there has been a ratchet higher in the spread. It has not been destabilising. Rather it’s been a slow and steady process. In its simplest terms, it effectively translates to an extra 25bp demanded by investors to take down Treasuries.

As we progress through 2025 there is no reason to expect this spread to narrow unless there is some material progress made in terms of deficit reduction. Even deficit containment is liable to pressure the spread wider, as this still equates to a growing supply of cumulative Treasury bonds on the market. Should the fiscal deficit numbers worsen, the risk is the 50bp spread trends wider by another 25bp to the 75bp area. There is no real science to this beyond a possible repeat of the widening seen so far.

We view this as the most likely mechanism whereby the elevated fiscal deficit position impacts the Treasury market. There would not be much market tolerance for a ratcheting higher in the quarterly re-funding requirement. The basic market assumption is that the re-funding amounts have broadly peaked, apart from a natural rise in line with the size of the economy. Any rise from here is a pure reflection of fiscal pressure risks pushing Treasuries participants toward demanding more price concessions.