Faltering US exceptionalism and the implications of higher Treasury yields
No country has an unlimited capacity to carry debt. Past rating downgrades point to the US having run out of its extra debt capacity
[SINGAPORE] US exceptionalism, which stems partly from its status as the world’s leading economy and provider of the world’s principal reserve currency, has afforded the US government some added scope to run high budget deficits and levels of debt at a highly affordable cost.
However, no country has an unlimited capacity to carry debt. Past rating downgrades to Aa1/AA+ indicate that the US has exhausted its extra debt capacity, compared to other AAA-rated countries with far lower debt ratios. Further fiscal deterioration in the US could lead to more negative rating actions, albeit slow ones, with one-notch cuts over several years.
Rating agency downgrades merely confirm what is already widely recognised, yet these concerns have not prompted the US government to improve the fiscal outlook. The recent rise in 30-year Treasury bond yields above 5 per cent, despite expectations of slower economic growth, highlights growing investor concern about the persistently deteriorating fiscal situation.
As at May 2025, the US gross national debt stood at US$36.2 trillion, up from US$11.15 trillion just five years ago – and it is continuing to grow. A full extension of the 2017 Tax Cuts and Jobs Act will likely add US$4 trillion to the primary deficit over the next decade. As a result, the federal debt burden is forecast to increase to 134 per cent of gross domestic product by 2035, from 122 per cent in 2024.
However, when assessing debt affordability, the net cost of debt relative to government revenues is more important than the debt ratio, and is estimated to be at 12.7 per cent this year, doubling from the 6.5 per cent levels of 2020.
If the Federal Reserve cuts interest rates toward 3 to 3.25 per cent by mid-2026, as we expect, yields across the curve should decline moderately, which will likely help to limit the debt service cost to 13.5 per cent of general government revenues by 2026.
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If, instead, US Treasury yields were to rise across the curve toward a weighted average of around 5 per cent and stay there, the net interest cost would rise by almost one percentage point of revenues every year, reaching about 17.2 per cent by 2030. We think debt service as a share of government revenue will likely rise further.
Financial deregulation could potentially lower borrowing costs. Regulations require financial institutions to hold sufficient buffers of highly liquid and safe assets – typically government bonds. Central banks may also accept only certain high-quality assets as collateral from commercial banks at their lending facilities.
While these policies enhance financial system stability and reflect prudent regulation, there is no proven minimum level of government bonds that banks or insurers must hold to be considered resilient. Raising requirements above a reasonable threshold does little for stability, but increases “natural” demand for government bonds from a captive investor base. Such regulations often affect commercial banks, insurance companies, pension funds and money market funds.
A current example is the debate over reforming the supplementary leverage ratio (SLR). Presently, large US banks must hold equity capital against all assets, including high-quality ones like US Treasuries. Loosening the SLR could be justified as supporting bank lending, but excluding US Treasuries from capital requirements would incentivise banks to hold more Treasuries, potentially enhancing market liquidity.
During the early stages of the Covid-19 pandemic, the Federal Reserve temporarily excluded US Treasuries and central bank reserves from the calculation of the SLR for banks. This resulted in 10-year US Treasury yields declining by 25 basis points during the exemption period.
What about the possibility of federal government revenues rising, especially with the imposition of tariffs by the US government? A 15 per cent effective tariff rate could generate an additional US$300 billion to US$450 billion in annual revenue over the next decade, depending on the impact on import volumes and the need to support sectors affected by retaliation.
This would represent 1 to 1.5 per cent of 2024 US GDP. However, higher tariffs do not necessarily result in higher revenue. The Peterson Institute for International Economics estimates that the economic damage caused by higher effective tariff rates can actually reduce potential revenue.
Tariffs are also likely to result in higher inflation, as pointed out by the Federal Reserve. This in turn would push up debt-service costs via the compensation investors receive for holding Treasury Inflation-Protected Securities (TIPS) when inflation was high. For example, if the tariffs add one percentage point to the US Consumer Price Index, the immediate additional cost of compensating holders of TIPS would be US$20 billion.
At some point, the US will need to reduce its deficit to a more sustainable level – whether by crisis, by choice, or by good fortune, such as by achieving above-trend real growth and moderate inflation through a productivity boost, or by financial repression, which encompasses a broad range of measures, taken directly or indirectly by governments, to facilitate the affordable financing of public debt by attempting to hold down real (inflation-adjusted) interest rates.
It is hoped that the US acts before the bond markets act. As Clinton-era strategist James Carville famously remarked: “I would like to (be reincarnated) as the bond market. You can intimidate everybody.”
The writer is managing director and chief investment officer (South Asia-Pacific), UBS Global Wealth Management. He is also an adjunct associate professor at the Nanyang Business School of the Nanyang Technological University.
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