Uncertainty around tariffs have fueled market volatility and heightened concerns around slowing growth coinciding with rising inflation in the US. Now, the Administration’s “One Big Beautiful Bill” is projected to add more than $3 trillion to US debt over the next 10 years, pushing bond yields higher and making US debt riskier for the lender. Moody’s have downgraded the US and recently there has been weak demand for US Treasuries. Are we facing a US debt crisis? And what should Australian investors do?
Throughout 2024 the US economy looked to be in good shape. The post-Covid supply chain inflation spike had subsided, inflation was coming back to the Federal Reserves’ preferred target of between 2% and 3%, and interest rate cuts had started and were projected to continue throughout 2025. Markets were robust and the S&P500 Index had one of its best annual returns on record.
But markets began to falter from the start of 2025 as the newly elected President Trump gave notice that he would start introducing tariffs when he took office. In early April, markets were shocked when Trump announced higher-than-expected tariffs on imports from 57 countries, which were scheduled to take effect on April 9 but in an abrupt reversal later the same day were suspended for 90 days.
This uncertainty around tariffs has played havoc with financial markets and has pushed US 10 yr bond yields higher in anticipation of higher inflation. This has forced the US Federal Reserve to keep interest rates on hold for the first half of the year, rather than the expected cuts which economists were predicting at the end of last year. Furthermore, the USD is falling relative to a basket of other currencies, indicating that sentiment is souring on the USD as the world’s reserve currency.
Rising US Sovereign Debt
Demand for US assets sank further amid prospects of a wider fiscal deficit after the House of Representatives passed Trump’s “One Big Beautiful Act" [1], which according to the Congressional Budget Office would add $US3 trillion to $US5 trillion to US debt over the next 10 years. In the lead-up to the passage of the bill, the US Treasury Department tried to secure $16 billion of funding through the sale of 20-year bonds but found the auction harder than usual to execute due to a lack of demand from investors.
Concerns about the US debt and deficit have led Moody’s to downgrade America’s credit rating, as US debt had become riskier for the lender. Longer-dated bond yields have been moving upwards, given the large debt burden that has to be refinanced in the future. US federal government debt is now projected to surpass its World War II - era peak. The Ernest Hemingway cliché – that America has been going bankrupt gradually and now suddenly [2] – is being tossed around.
Could the US Default on its Debt Obligations?
US sovereign debt would become a crisis if there was a sudden, large and sustained downturn in demand for Treasury securities. A recent paper by economists at the Brookings Institution [3] lays out four scenarios in which that could happen but concludes that none of them are likely.
Firstly, a big holder of Treasuries (like China) could abruptly start selling. But even China holds just 3% of outstanding US debt and a selloff wouldn’t necessarily change other investors’ view on the value of Treasuries.
Secondly, US Congress could fail to raise its debt ceiling. If that happened, it might not last long — since market turmoil would prompt Congress to reconsider — plus the Fed and Treasury could temporarily calm markets.
Thirdly, the Federal Reserve could signal it’s willing to tolerate higher inflation to lower the value of US debt. The authors argue this simply wouldn’t work since so much US debt is short-term and would quickly need to be rolled over at higher interest rates.
And finally, the US could decide that default was its best option. Again, the authors think this option is unlikely because it wouldn’t solve much. It would hurt US investors, who own 70% of US federal debt, and would make new borrowing near impossible.
The chance of a debt crisis was low, the authors wrote, “so long as the US retains its strong institutions and a fiscal trajectory that isn’t vastly worse than the one currently projected.”
Is the US Heading for a Recession?
While the possibility of the US defaulting on its debt is remote, if US government bond yields continue to rise, it does risk pushing the US into recession, and with it the global economy. This is because many assets and securities across the globe use US Treasury bonds as a reference rate.
All economists agree that a US recession is coming at some point – but nobody knows when. But keep in mind that the US economy has several key supports if there is a slowdown. Private sector balance sheets are in a relatively healthy position, fiscal policy will remain supportive, and the US Federal Reserve has plenty of room to cut rates should the economy start to seriously falter.
As an investor, the best way to plan for an unknowable downturn in the economy is to stay disciplined in a diversified portfolio that has been designed to meet your goals. Market corrections and unplanned economic downturns are a natural part of investing.
[1] The US House of Representatives narrowly passed the One Big Beautiful Bill Act on May 22nd, and it is now with the Republican-dominated Senate. Amendments are expected before the bill becomes law, but the major expected impacts are extension of tax cuts from President Trump’s first term, some incremental tax benefits to both high- and low-income demographics, and targeted spending cuts. The net fiscal impact is estimated at US$3 trillion additional federal debt over the next decade, and the bill itself proposes an increase of the national debt ceiling to accommodate this.
[2] Here is the actual quote from Ernest Hemmingway’s The Sun Also Rises: “How did you go bankrupt? Two ways. Gradually, then suddenly.”
[3] https://www.brookings.edu/articles/assessing-the-risks-and-costs-of-the-rising-us-federal-debt/
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