The Deficit Spiral

Setting the Stage

The United States’ deteriorating fiscal position is beginning to cast a shadow over Wall Street’s rally since mid-April. Last Monday, investors sold out of government bonds and the dollar after Moody’s stripped the U.S. of its final triple-A credit rating. The downgrade, driven by concerns over persistent budget deficits and mounting interest costs, sparked renewed anxiety about the government’s long-term fiscal sustainability.

While stocks managed to sidestep major losses following the news of the downgrade, bond markets were rattled. Selling pressure on the long end of the curve pushed yields above 5% – flirting with their highest levels in over a decade. Adding to market jitters around the U.S. deficit was the House Budget Committee’s approval of President Trump’s “Big Beautiful” tax and budget reconciliation bill. The proposal includes an extension of the 2017 tax cuts, new deductions such as exemptions on tips or overtime pay, increased defense and border security funding, and a repeal of climate-related tax credits. According to the Committee for a Responsible Federal Budget, a non-partisan group of economists, the legislation would add more than $3.3 trillion to the federal debt over the next decade. White House Press Secretary, Karoline Leavitt, stated the bill would save the federal government $1.6 trillion in an interview on Monday. On Thursday the Republican-led House passed the sprawling tax-and-spending bill after party leaders made a series of last-minute changes. The measure will now go to the Senate.

Economics 101

Before diving deeper, it’s worth revisiting the Economics 101 classroom to understand the fundamentals of how government deficits work – and more importantly, why they matter. At its core, a federal deficit occurs when the government spends more in a given year than it collects in revenue, primarily through taxes. In fiscal year 2024, the U.S. government took in $4.92 trillion in revenue but spent $6.75 trillion, resulting in a deficit of $1.83 trillion – an increase of $138 billion over the previous year. So far in fiscal year 2025, the U.S. government has spent $1,048,730,267,578 more than it has collected according to Treasury data.

Yes, that’s a VERY big number. However, running a deficit is not a new phenomenon. Over the past 50 years, the federal government has recorded a budget surplus just four times – the most recent being in 2001. The size of the national deficit tends to reflect both economic conditions and fiscal policy. In times of economic weakness, tax revenues often decline while spending – especially on safety nets and stimulus – rises, deepening the deficit. Conversely, in periods of strong economic growth, revenue tends to increase, and deficits may shrink.

It’s also important to distinguish between the deficit and the national debt – terms often used interchangeably but meaningfully different. The deficit is the annual shortfall between spending and revenue. The national debt is the cumulative total of past deficits (minus any surpluses), built up over time. Think of the federal budget as a household. The federal deficit is how much more the household is spending than earning this year. The debt is the total outstanding credit card balance. To finance that annual gap, the government borrows money by issuing Treasury securities. Over time, this borrowing adds to the national debt and thus, the burden of interest payments owed to investors also grows.

Drivers of the Deficit

Federal spending falls into three major categories: mandatory spending, discretionary spending, and interest payments on existing debt. Mandatory spending includes entitlement programs like Social Security, Medicare, and Medicaid. As of 2025 FYTD 22% of federal spending has gone to Social Security, 13% to Medicare, and 13% to other health-related expenditures within the Department of Health and Human Services.

Discretionary spending – which Congress sets annually – includes funding for defense, education, and infrastructure. So far in 2025 FYTD,13% of spending has gone to defense, 3% to education and social services, and 2% to transportation and infrastructure.

Interest payments are the fastest-growing component of government spending. In 2025 FYTD, 14% of all federal spending has gone toward net interest on existing debt. That’s nearly $1 out of every $7 the U.S. spends – more than the total spent on defense. And just in case it wasn’t already known, the U.S. has the #1 military in the world. That’s a lot of interest.

The U.S. federal deficit is projected to hit $1.9 trillion by the end of fiscal year 2025, a level typically associated with wartime or recessionary periods. This has forced the Treasury to ramp up borrowing, with gross issuance reaching $9.9 trillion as of April, marking a 1.4% year-over-year increase. The significant borrowing comes at a cost: interest payments are expected to reach $952 billion in 2025, nearly triple the amount from 2020. These interest payments are expected to consume 18.4% of federal revenues by the end of 2025, the highest share since 1991.

Market Implications

The escalating U.S. federal deficit and mounting national debt are exerting significant pressure on financial markets, influencing investor sentiment and asset valuations. What makes this moment unique is that the deficit is expanding despite a relatively strong economy.  As stated previously, during times of slow economic growth or a recession, deficits tend to rise as tax revenues plunge and government spending increases in an attempt to revive growth and help the unemployed. This begs the question, if we’re running this level of deficit now, what happens if the economy does in fact dip into a recession?

The potent combination of an increased supply of long-term U.S. Treasuries mixed with lackluster demand at auction has signaled waning investor appetite for the long bond. In turn, yields have felt upward pressure. The yield on the 30-year Treasury surpassed 5% in the trading week following Moody’s downgrade of the U.S. credit rating. It ended Monday, May 19th’s trading session at 4.937% while the yield on the 10-year settled to 4.473%, up from 4.437% on Friday. By Friday May 23rd, the 30-year was at 5.04% and the 10-year was at 4.52%. The rise in yields has implications for various sectors, including housing and corporate borrowing, potentially leading to higher mortgage rates and increased costs for businesses.

While equity markets initially scoffed at the bond market uneasiness and showed modest gains the Monday after the credit downgrade major indices have remained volatile. Stocks have experienced a significant rally following a number of measures by the current administration to walk back aggressive tariff measures. This post-reprieve rally came to a screeching halt on Tuesday and major indices ended the week on a sour note. On May 21 the S&P declined 1.5%, the Dow fell 1.8%, and the Nasdaq dropped 1.3%. As of the end of the trading day on May 23rd the S&P slid 2.61% for the week, the Dow was down 2.47%, and the Nasdaq dropped 2.39%. While indices bounced back after the long holiday weekend and the S&P 500 is in the green YTD, investor caution and uncertainty looms amid fiscal and monetary uncertainties.

Overall, the recent news of the U.S. credit downgrade has further exacerbated market jitters. This has prompted investors to reassess the risk profile of U.S. government securities, potentially leading to higher borrowing costs and reduced demand for Treasuries.

Borrowed Time

The long-term risks of sustained, outsized deficits are becoming harder to ignore. In a recent interview with Bloomberg, JPMorgan CEO Jamie Dimon sounded the alarm:

“Our deficit is almost two trillion dollars – 6 or 7% of GDP – the largest peacetime deficit ever… Does that create risks? Absolutely. It creates risk of inflation; it creates risk of higher long-term rates.”

Dimon’s concerns are shared by many economists. Continued borrowing could crowd out private investment, as the government debt absorbs more of the available capital in financial markets. To Dimon’s point, as the government competes for limited capital, interest rates may rise, making it more expensive for businesses to borrow and invest. This ultimately can stifle economic expansion and innovation.

There’s also the risk of entering an era of fiscal dominance which causes central bank policy to become constrained by the need for the government to finance its debt – once again potentially leading to inflationary pressures or limits on rate policy.

Finally, high deficits reduce the government’s flexibility to respond to future emergencies. Whether it’s an economic recession, a pandemic, or a natural disaster, the government may find it challenging to increase spending or cut taxes to stimulate the economy. The lack of fiscal flexibility can hinder effective policy responses, exacerbating economic downturns.

Despite the risks, it’s important to understand realities: meaningful deficit reduction remains elusive in a polarized political environment, and cuts to large entitlement programs are politically toxic. While concerns over the U.S.’s fiscal sustainability have lingered for decades without sparking crisis, rising borrowing costs and weakening global demand for Treasuries may soon test that patience.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice.  All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.  Please consult a tax or legal professional for specific information and advice.

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