National Debt, Deficits, and Interest Rates: Economic and Market Impacts

National Debt, Deficits, and Interest Rates: Economic and Market Impacts

Historical Impacts of U.S. Debt and Deficits on the Economy and Markets

Throughout U.S. history, periods of rising national debt and large fiscal deficits have had varied effects on economic performance and investor sentiment. After World War II, U.S. debt exceeded 100% of GDP, but strong post-war growth and inflation helped shrink that ratio over subsequent decades. In the late 20th century, however, persistent deficits became more common. In the 1980s, twin deficits (large federal budget and trade deficits) and high interest rates were among factors that spooked investors during the 1987 stock market crash. This “Black Monday” crash saw the Dow Jones plunge over 22% in one day, partly attributed to fears that heavy government borrowing and rising rates were unsustainable. In the 1990s, by contrast, fiscal discipline (including spending restraints and revenue increases) produced budget surpluses late in the decade, which coincided with low interest rates, robust economic growth, and strong stock gains. This history suggests that improving fiscal balance can bolster economic confidence, whereas rapid debt accumulation can at times undermine it.

Several debt-related crises underscore how debt fears can roil markets. A notable example is the 2011 debt-ceiling crisis. Amid a political standoff over raising the debt limit, the U.S. came perilously close to default. Although default was averted at the last minute, the brinkmanship led Standard & Poor’s to downgrade the U.S. credit rating from AAA to AA+ for the first time ever. Investor reaction was swift: stocks tumbled, the S&P 500 index lost nearly 11% in the 10 days surrounding the downgrade, and volatility spiked.  Although markets eventually stabilized, the 2011 episode showed that doubts about U.S. debt can trigger significant downturns in equities and raise borrowing costs. Other government funding impasses (such as budget shutdowns or subsequent debt-ceiling scares in 2013 and beyond) similarly caused short-term market volatility, though with less severe impact than 2011.

It’s worth noting that government debt concerns have also fueled crises abroad, illustrating a broader principle. For example, Europe’s sovereign debt crisis (2010–2012) erupted when investors lost confidence in several countries’ fiscal sustainability. Higher than expected deficit levels can erode investor confidence, causing bond spreads to rise to uncomfortable levels. Greece, Italy, and others saw borrowing costs soar and required painful austerity measures and bailouts. While the U.S. has not faced a similar loss of market access, these episodes show how quickly sentiment can change once debt loads are perceived as unsustainable. In the U.S., even without an external funding crisis, high debt can still influence economic conditions by nudging interest rates up and confidence down. For instance, heavy U.S. borrowing in the 1980s led to worries about “crowding out” private investment; indeed, 10-year Treasury yields climbed above 10% in that era, and equity valuations fell until fiscal and monetary policies stabilized.

Current Risks of a Growing National Debt and Deficit

Today, the United States faces historically high debt and persistent deficits, raising concerns about economic stability and investor confidence. Federal debt held by the public is now roughly equal to the nation’s entire annual GDP – around 98–100% of GDP in 2024, the highest debt burden since just after WWII. In dollar terms, gross federal debt exceeds $30 trillion. Annual budget deficits are unusually large even in the absence of recession: the FY2023 deficit was about $1.7 trillion (roughly 6% of GDP), and deficits are projected to remain at or above 6% of GDP for the coming decade under current policies. Running such high deficits during peacetime and full employment is virtually unprecedented and points to a structural imbalance between spending and revenues. This imbalance is “unsustainable”, according to the Congressional Budget Office and fiscal analysts, meaning debt will keep growing faster than the economy unless policy changes.

Key current concerns include:

·      Rising Interest Costs: The cost to service the debt is climbing rapidly as interest rates increase. In FY2024 the U.S. spent $882 billion on interest – an 86% jump from just two years prior. Interest payments are consuming a growing share of federal spending, approaching the scale of major programs like defense or Medicare. This diverts resources from productive investments and could eventually force painful budget trade-offs. As debt rises, so do interest costs, which can squeeze out investments in our shared future in areas like infrastructure, education, and R&D. A larger debt also means higher borrowing rates for everyone: investors may demand higher yields on Treasury bonds to compensate for greater U.S. credit risk, which in turn pushes up borrowing costs economy wide. Companies issuing bonds and consumers taking loans all face higher rates when government debt issuance is vast and perceived as risky.

·      Crowding Out and Slower Growth: When the government continually finances large deficits, it can “crowd out” private investment by soaking up available capital. Over time, this can reduce business investment in plants, equipment, and innovation, leading to weaker productivity growth. The Brookings Institution notes that debt growing faster than the economy will “push up interest rates and crowd out increasing amounts of private investment,” leaving future generations with lower living standards than otherwise. In essence, a high-debt environment could be a drag on long-term economic growth. The Penn Wharton Budget Model likewise projects that, absent fiscal reform, rising debt will eventually weigh heavily on GDP growth, as the need to finance interest costs either requires higher taxes or cuts into productive spending.

·      Reduced Fiscal Flexibility: A large debt load can limit the government’s ability to respond to crises or downturns. If a recession or another emergency hits, high debt may constrain the scope for fiscal stimulus or require the Federal Reserve to intervene more (which can carry its own risks). The Peterson Foundation warns that heavy debt “limits the ability of the government to respond to the unexpected” and “weakens our economy,” making it harder to support a robust safety net or recovery measures. In other words, high debt is a vulnerability – the government might be forced into austerity at the worst time if investors grow fearful, exacerbating economic instability.

·      Investor Confidence and Credit Ratings: Perhaps the most immediate risk of excessive debt is a loss of confidence among investors in U.S. Treasuries. Thus far, the U.S. has continued to finance its debt at “moderate” interest rates by historical standards, thanks in part to the dollar’s reserve currency status. However, signs of strain are emerging. In 2023, Fitch Ratings downgraded the U.S. credit rating from AAA to AA+, citing “a steady deterioration in governance… on fiscal and debt matters” and repeated debt-ceiling standoffs that “eroded confidence in fiscal management”. This followed S&P’s downgrade in 2011 for similar reasons, which S&P officials now feel was vindicated by the subsequent surge in debt and continued political polarization. While U.S. Treasuries are still seen as one of the safest assets, these actions highlight a gradual erosion of trust. If major buyers of U.S. debt (domestic or foreign) demand higher yields or reduce their purchases, the government could face a “fiscal crisis”, defined as a sharp, sustained spike in interest rates coupled with a steep fall in the dollar and equity markets. In essence, a tipping point could come where markets suddenly question U.S. solvency or willingness to pay, forcing a disruptive adjustment.

All these factors contribute to a cautious outlook. Many economists argue the U.S. must stabilize its debt trajectory to avoid these risks. As the Council on Foreign Relations summarizes, a rapidly mounting debt load could soon diminish U.S. economic growth, restrict government spending on key programs, and raise the likelihood of financial crises. Investors and analysts are increasingly focused on fiscal indicators: for example, recent Treasury auctions have seen “soft demand” and tailing bids, meaning the Treasury had to offer higher interest rates to attract buyers. Such developments hint that markets are starting to demand a risk premium for U.S. debt. While there is no immediate panic, the “alarm bells” are ringing louder.

Outlook: Debt Trajectory and Potential Future Effects

Looking ahead, the projections for U.S. debt and deficits are sobering. The Congressional Budget Office (CBO) projects federal debt held by the public will resume an upward climb, exceeding the prior WWII-era record (106% of GDP) within a few years and reaching roughly 118% of GDP by 2035 if current trends continue. Annual deficits are forecast to hover in the $2 trillion range within the next decade (about 6–7% of GDP), even assuming no major wars or recessions. Over the longer term, as Baby Boomers retire and healthcare costs rise, entitlement spending will put further pressure on the budget. Absent reforms, debt could double the size of the economy within 30 years. Such a trajectory is widely deemed unsustainable. Many experts fear that long before debt hits extreme levels, investors would force a correction. Analysts at the Penn Wharton Budget Model estimate that under current fiscal policy, markets will only tolerate about 20 more years of similar deficits before debt dynamics become unmanageable. In their view, by the 2040s the U.S. would hit a point where “no amount of future tax increases or spending cuts could avoid default…whether explicitly or implicitly (i.e., via high inflation)”. In other words, without course correction, a debt crisis of some form is likely within a couple of decades. This is a worst-case scenario, but it underlines the importance of altering the fiscal path. (Some analysts are less dire, noting the U.S. has more leeway because of its unique position in global finance, but our research team at Elevate Capital fully agree that rising debt will gradually erode economic vitality.)

For the economy and stock markets, a continually growing debt burden poses mixed implications. In the best case, if the U.S. manages its debt without a crisis, we might see a slow squeeze: higher interest costs and periodic political battles over budgets could gradually dampen growth and keep markets on edge. Equity investors could demand higher earnings yields (i.e. lower price-to-earnings ratios) to compensate for a riskier fiscal environment, which would cap stock valuations. Periodic fears about the debt (or actual austerity measures to rein it in) might trigger bouts of volatility or modest downturns rather than full-blown crashes. In the worst case, a loss of confidence could precipitate a sharp sell-off in bonds and stocks as outlined by Brookings’ fiscal crisis scenario – essentially a self-reinforcing spiral of rising rates, a falling dollar, and sinking equities. While the timing and likelihood of such an extreme event are uncertain, the current trend “inevitably” heads toward some form of reckoning. This cloud on the horizon has made investor confidence somewhat fragile; for instance, surveys of fund managers in late 2023 showed government debt levels climbing on the list of potential market risks.

On the positive side, thus far the U.S. economy has proven resilient, and stock markets continue to perform well despite high debt – a phenomenon that has surprised some economists. This resilience is partly because, until recently, interest rates were very low, making the debt burden affordable. Also, global demand for dollar assets remained strong. Going forward, a critical assumption is that the U.S. will take steps (gradual tax increases, spending reforms, etc.) to signal fiscal responsibility, thereby maintaining creditor trust. If such steps are taken, the “tipping point” could be delayed or avoided, and the debt drag might be managed through growth and moderate inflation. In any case, investors will be closely watching fiscal policy. Major rating agencies and institutions have made clear that failure to address the debt could “raise the likelihood of financial crises” and undercut America’s economic leadership. Thus, the trajectory of debt and deficits is likely to be a key factor shaping U.S. economic stability and market performance in the coming years. Prudence suggests that keeping debt on a sustainable path would bolster long-run investor confidence, whereas continuing the current path raises the risk of turmoil down the road.

High Interest Rates and Their Impact on Stock Valuations

Rising interest rates have a significant cooling effect on stock valuations. There are a few channels through which high rates reduce equity prices: a higher discount rate applied to future earnings, increased borrowing costs for businesses (which can hurt profits), and the appeal of bonds as an alternative to stocks. These factors tend to put downward pressure on stock prices, all else equal.

·      Higher Discount Rates = Lower Present Values: Stock values are fundamentally based on the present value of expected future earnings or cash flows. When interest rates (and by extension, the discount rate) rise, those future earnings are worth less today. In valuation models, a higher rate means you discount future cash flows more steeply. Higher interest rates also mean future discounted valuations are lower because the discount rate used for future cash flow is higher. This effect is especially pronounced for growth stocks or any company whose earnings are projected to grow years into the future. Such stocks derive a large portion of their valuation from distant earnings; when you discount those distant earnings at a higher rate, the stock’s intrinsic value drops. For example, the high-flying technology stocks of the past decade saw extremely rich valuations when rates were near zero. But as rates jumped in 2022–2023, those lofty price/earnings multiples came down because investors could no longer justify paying as much for earnings that might not materialize for several years. Historically, we see the inverse relationship clearly: in the early 1980s, when inflation and interest rates were in the double digits, stock valuations fell to very low levels (single-digit P/E ratios by 1981). By contrast, the ultra-low rates of the 2010s helped boost the S&P 500’s valuation to historically high levels, as low rates push down the discount rate and the cost of a stake today in a company’s future earnings, thereby supporting higher prices. Now that the era of near-zero rates is over, equity valuations have begun adjusting.

·      Increased Borrowing Costs for Companies: High interest rates raise the cost of debt for businesses, which can cut into corporate earnings and constrain expansion. Companies frequently borrow to finance operations, new projects, or share buybacks. When rates rise, existing variable-rate debt becomes more expensive to service, and new debt financing carries higher interest payments, directly reducing net income. Heavily indebted firms are most vulnerable: “High borrowing costs can discourage businesses from future investment and may pose risks to weak firms with limited earnings,” the Federal Reserve Bank of Kansas City observes. Many companies took advantage of cheap credit during the low-rate years; as those bonds and loans mature, they will have to refinance at much higher rates, which will erode profit margins. Even broadly, S&P 500 companies saw interest expenses climb in 2022–2023, contributing to slower earnings growth. When corporate profits are under pressure from rising interest costs, stock prices typically reflect that. Moreover, business investment tends to slow when interest rates are high as fewer projects meet the hurdle rate for profitability. This can reduce future growth prospects for companies, leading investors to value them less richly. In sum, higher rates act like a tax on corporate earnings, particularly for sectors like utilities, real estate, and any industries reliant on debt financing. (Notably, one sector that can benefit from rising rates is financials, especially banks, which can earn more on loans – indeed, financial stocks often buck the trend of rate-driven declines. But if rates rise too far or too fast, even banks suffer as credit demand falls and loan defaults may increase.)

·      Shift in Investor Preferences: When safe bonds and cash offer higher returns, some investors reallocate away from stocks, exerting additional downward pressure on equity valuations. For much of the past decade, low interest rates left investors with few alternatives to stocks (“TINA – There Is No Alternative” was a common refrain). As a result, stocks commanded high valuations. Now, with the 10-year Treasury yield around 4–5% (versus ~1% in 2020), fixed-income securities present a more compelling return. This raises the bar for equity returns as investors will only take the extra risk of stocks if they see the potential for significantly higher returns than bonds. If bond yields rise, stocks often adjust by dropping in price until their expected yields (earnings/price or dividends/price) become attractive by comparison. In practical terms, higher interest rates have led to portfolio rebalancing: for instance, pension funds and income-focused investors may shift some allocation from equities into newly higher-yielding bonds, which can dampen demand for stocks. This dynamic played out in 2022, when the Federal Reserve’s rapid rate hikes saw the S&P 500 fall nearly 20% and the NASDAQ fall over 30%, while bond funds finally delivered positive yields. The stock declines reflected both the direct valuation effects discussed above and this rotation of capital toward fixed income.

In light of these factors, it’s clear why high interest rates are generally a headwind for the stock market. Research shows that, in general, stock prices and interest rates move inversely: as interest rates move higher, stock prices tend to move lower, all else equal. There are of course exceptions and complicating factors (for example, if rates are rising due to a very strong economy, corporate earnings might be climbing enough to offset some valuation pressure). But the fundamental mechanisms remain; higher rates = higher discount rate, higher costs, and more competition for investor dollars, which usually mean lower equity valuations than would prevail with low rates.

Historical data back this up. The late 1970s and early 1980s, as mentioned, saw extremely high interest rates (the Fed’s policy rate hit ~20% in 1980–81) and during that period stock valuation multiples were at generational lows. In contrast, the 2010s had ultra-low rates and correspondingly elevated stock valuations (the S&P 500’s cyclically adjusted P/E reached levels rivaled only by the 1920s and late-1990s bubbles). Today, with rates off the floor, we are seeing a normalization. The S&P 500’s forward P/E has compressed from the mid-20s down to the high-teens, and speculative high-growth stocks have been repriced more sharply. If interest rates remain “higher for longer,” as many experts forecast, companies and investors will continue adapting. Corporations might prioritize paying down debt and controlling costs, given the higher expense of borrowing. Investors may favor stocks with solid current earnings and dividends (value stocks) over those whose payoff is far in the future (growth stocks), since nearer-term cash flows hold up better under high discount rates. Sectors like utilities and real estate – often termed “rate-sensitive” because of their heavy debt usage and bond-like income profiles – could lag, whereas sectors like financials or energy might be relatively resilient. These are trends already observed in recent market performance.

In summary, elevated interest rates challenge stock valuations by both mathematics and behavior. The mathematical effect is through discounting future earnings more severely, and the behavioral/economic effect is through tightening financial conditions for businesses and offering investors viable alternatives to equities. This doesn’t necessarily portend a market crash. It’s more about recalibrating what constitutes a fair price for stocks. The 10-year Treasury yield serves as a key barometer for risk assets such as stocks, and once that yield moves above certain thresholds (e.g. sustained over 5%), it would certainly be more problematic for equities. Investors and corporate leaders are aware of these dynamics. In fact, many companies are adjusting their strategies (focusing on efficiency, locking in fixed-rate debt where possible, etc.), and investors are seeking a balance between stocks and bonds as the relative attractiveness shifts. Over the long run, stock returns will depend on companies’ ability to grow earnings and on the prevailing level of interest rates. If the U.S. can get inflation and rates back to moderate levels, stock valuations could stabilize or even expand again. But if rates stay high due to either Federal Reserve policy or debt-driven fiscal pressures, valuation multiples are likely to stay under pressure, acting as a modest brake on future stock market gains.