Latest / The National Debt Podcast with Fexingo: Treasury, Borrowing, and Long-Term Fiscal Outlook / Why The Deficit Is Shrinking Despite Higher Rates
Transcript
- Lucas: Here is the headline that should be making your Tuesday morning coffee taste a little different: the federal deficit just shrank to minus 1.77 trillion dollars for the quarter ending September thirty-first, twenty twenty-five. Luna: That sounds like good news for fiscal hawks, but we know the ten-year Treasury yield is sitting at four point eight three percent right now, so borrowing costs are clearly still climbing. Lucas: Exactly, and this is where the narrative gets tricky because the deficit is shrinking not because we are raising taxes or cutting big programs, but because revenues are holding up better than expected while some discretionary spending has stalled. But look at the debt to gdp ratio, it ticked up to twelve point two six percent on January first, and that number doesn't lie about the long-term pressure. Luna: So we are seeing a temporary reprieve in the cash flow problem while the underlying debt stock keeps growing, which means the real story is about what happens when those interest payments start eating into the actual budget. Lucas: Right, and you have to remember that interest on the debt is no longer a line item you can just adjust; it is becoming a fixed cost that competes with defense, infrastructure, and education for the same pool of dollars. We are watching the gap between the three-month Treasury yield at three point nine five percent and the ten-year at four point eight three percent widen, which tells us the market is pricing in persistent inflation risk that will keep refinancing expensive for years. Luna: It feels like we are managing a liquidity squeeze without actually addressing the solvency question, especially with foreign buyers exiting U.S. Treasuries as we saw in those recent reports. Lucas: That exit strategy by foreign holders is critical because it removes the passive demand that used to absorb our issuance, forcing domestic institutions and the Federal Reserve to step in more aggressively. And when you combine that with the fact that wholesale prices rose zero point four percent in August, you get a clear picture of why the Fed is debating rate hikes next week instead of cuts. Luna: So if rates stay higher for longer, the debt service burden accelerates faster than the deficit can shrink, creating a feedback loop that makes any future fiscal consolidation much harder. Lucas: Precisely, and the math is brutal because every basis point increase in the average interest rate adds billions to the annual bill without Congress having to pass a single new law. We are looking at a scenario where mandatory spending swallows up the surplus before anyone can even think about paying down principal. Luna: I wonder if investors are starting to price that political paralysis into the spread, since there is really no bipartisan mechanism to force spending discipline right now. Lucas: They definitely are, and you see it in the steepening of the curve, with the thirty-year Treasury yield climbing to five point two eight percent as traders demand a premium for holding long-duration risk over the next decade. Luna: That premium is essentially an insurance policy against fiscal irresponsibility, which means anyone buying those long bonds is betting they will get paid back in dollars that might not be worth much. Lucas: And that brings us to the donation segment because if walking through the economy with us has made something click, we deliberately don't run ads on these shows, and if you want to support that choice, the link is buy me a coffee dot com slash fexingo. Luna: It is just a small way to keep the signal clean and the analysis independent, so thanks for listening and helping us keep the lights on. Lucas: Now, back to the numbers, because the real danger here is not the deficit itself but the composition of the spending driving it, specifically how entitlement growth is locking in costs that outpace wage growth for the middle class. Luna: It is hard to argue with that dynamic when you look at the labor data, since payroll growth is steady but real wages are still struggling to catch up with the cumulative inflation of the last few years. Lucas: Right, and when you add the import ban on Canadian goods into the mix, you introduce another layer of supply chain friction that could push wholesale prices higher, further complicating the Fed's ability to stabilize the dollar without crushing growth. Luna: So we are dealing with a perfect storm where fiscal policy is too rigid to adjust, monetary policy is too constrained by inflation, and trade policy is adding unnecessary drag to the system. Lucas: And that rigidity is exactly why the debt to gdp ratio continues its slow climb, even though the annual deficit looks smaller on paper, because the denominator, GDP, is growing slower than the numerator, total debt. Luna: It feels like we are drifting toward a situation where financial repression becomes the only option, meaning the government forces domestic banks to hold more debt at artificially low rates to keep the system stable. Lucas: That is a very real possibility, and it would explain why the Fed Funds effective rate is holding flat at three point six three percent despite the upward pressure from the CPI report due Friday. Luna: If they hike next week, it might just be a defensive move to anchor expectations, but it won't fix the structural imbalance that is draining federal revenue. Lucas: Exactly, and when you look at the Interest on Reserve Balances sitting at three point six five percent, you see how the Fed is already paying massive amounts to banks just to keep reserves in the system, which is another hidden cost of this monetary stance. Luna: So the government is paying higher rates to the Fed, which then pays banks, and everyone is waiting for the private sector to absorb the rest of the issuance, but there is less appetite for that now. Lucas: That lack of appetite is why the Treasury General Account balances are being watched so closely, because they represent the last buffer before the government has to issue debt at potentially disruptive levels to fund operations. Luna: It is a fragile equilibrium, and one bad inflation print could tip the balance, forcing a rapid repricing of all long-term assets across the board. Lucas: Which is why we need to stop treating the deficit as a quarterly accounting exercise and start viewing it as a multi-decade solvency challenge that requires structural reforms no politician wants to touch today. Luna: Agreed, because until someone addresses the root cause of mandatory spending growth, these periodic deficit shrinks will just be illusions that mask the accelerating cost of borrowing. Lucas: And that illusion is dangerous because it gives policymakers a false sense of security while the ten-year yield keeps creeping higher, testing the limits of what the market can absorb without volatility spiking. Luna: So the lesson for investors is to assume the trend is up, both in rates and in the debt burden, and price your portfolios accordingly rather than hoping for a return to the low-rate era of the past decade. Lucas: That is a pragmatic approach, because the data from September tenth confirms that the macro environment is shifting, and clinging to old models will only leave you exposed to the next shock. Luna: We will see how the CPI data lands tomorrow, but until then, the safest bet is to acknowledge that the fiscal landscape has fundamentally changed and adapt your strategy to match that new reality. Lucas: Let's hope the data brings some clarity, but regardless of whether inflation cools or heats up, the underlying debt dynamics remain the dominant force shaping the economic outlook for the rest of the year. Luna: Absolutely, and keeping a close eye on those Treasury yields will tell us everything we need to know about where the market thinks this trajectory is heading next. Lucas: Until then, we will keep tracking the numbers and breaking down the signals, so stay tuned for what comes next in this evolving story.