As large US budget deficits raise questions about debt sustainability, fiscal concerns are beginning to affect prices for longer-maturity government bonds and the US dollar. There are signs, however, that the country’s equity market will power ahead.
Goldman Sachs Research’s economic outlook for the US, meanwhile, is on the cautious side, set against a backdrop of tariff increases: Our economists estimate the average effective tariff rate will rise about 14 percentage points in 2025 and another 3 percentage points next year to nearly 20% in 2026.
How will tariffs affect the US economy?
US GDP is forecast to expand about 1% in the fourth quarter (year over year), says Chief Economist Jan Hatzius on an episode of The Breaks of the Game podcast. The risk of recession is around 30%, which is double the historical average.
“On the economy, it’s going to continue to be a slog,” Hatzius says in the episode, hosted by Tony Pasquariello, global head of hedge fund coverage in Global Banking & Markets. “Growth is going to continue to be quite slow.”
While import taxes have had little impact on prices so far, Hatzius expects core inflation to increase by about a percentage point to more than 3% this year. The rise in inflation will weigh on consumer spending. “It’s already on the soft side,” Hatzius says. “It has stagnated, which doesn’t often happen outside of recession.”
How will US deficits affect Treasuries and the dollar?
While there are signs investors have started to come to terms with higher tariffs in the US, deficit concerns have become a larger focus.
Kaplan says deficit concerns are beginning to filter through prices for longer-maturity US government bonds. Investors are charging more to hold longer-term government securities, known as the term premium. And while Treasuries have long been the world’s haven asset, longer-dated bonds haven’t rallied this year even as estimates for economic growth have declined.
Hatzius says he used to be “more sanguine” about the US fiscal outlook. Following the financial crisis in 2008, for example, the large budget deficit was accompanied by elevated unemployment. Interest rates were far below the rate of real (inflation adjusted) trend GDP growth, which helped accommodate a larger deficit.
“A lot of that has changed,” he says. The economy clearly isn’t underemployed, and real interest rates are much higher. The rate on 10-year Treasury Inflation-Protected Securities is roughly in line with the trend growth rate of the US economy. “And that means we can afford only a much smaller deficit,” Hatzius says. He notes that the deficit ratio would need to be several percentage points lower than it is now in order to stabilize the increase in debt-to-GDP.
That said, US government bond yields have risen enough that the securities are likely to be attractive to private investors, says Ashok Varadhan, co-head of Global Banking & Markets at Goldman Sachs. That’s a change from the period between the Global Financial Crisis through the Covid pandemic when real, inflation adjusted, interest rates were negative.
Many investors have become more bearish on the US dollar amid fiscal concerns, and Goldman Sachs Research expects further depreciation in the currency. But Varadhan points out that the US isn’t the only developed market with an unusually large budget deficit. The US budget deficit this year is estimated to be about 6% of GDP, while the deficit of France is 5.5%, and the UK 3.6%, according to Goldman Sachs Research. Varadhan suggests that assets like gold and bitcoin could climb relative to fiat currencies.
The outlook for US stocks amid rising deficits
Kaplan notes that, while higher deficits may create challenges for longer-term Treasury yields, the net stimulus may boost GDP growth in the short run. The net stimulus plus substantial investments in AI may help explain why overall corporate earnings are likely to remain resilient.
AI’s capacity to deliver increased productivity is going to be critical in the coming years, Kaplan says. Many populations are aging, and many countries have higher-than-usual levels of debt to GDP. That makes innovation and increases in productivity particularly important.
Varadhan says he’s “super bullish” on equities, even though they’ve reached all-time highs. There’s a tailwind to the US economy from deregulation, and it will be crucial to assess whether the US manages a fair recalibration of trade and continues to attract the best, brightest, and most able people to its labor market.
“We’re not even in the first inning of companies implementing AI,” Varadhan says. “Once that company implementation happens, you get that productivity dividend.”
