Debt, deficits and the ‘One Big Beautiful Bill Act’: putting rising bond yields into context

President Donald Trump’s ‘One Big Beautiful Bill Act’ (the bill) has passed through the House of Representatives. This comprehensive tax and spending bill is expected to reach President Trump’s desk by the 4 July following Senate revisions. The prospect of even looser fiscal policy at a time when US Government spending already greatly exceeds revenues has unsettled bond markets, reviving fears that the growing deficit could lead to higher government bond yields.

The rising global government debt burden is likely to exert upward pressure to longer term yields, posing challenges for bond markets. This highlights the importance of multi-asset investing – diversifying investments not only in stocks and bonds but also in alternatives such as gold, hedge funds, and infrastructure to protect against potential risks in the bond market. 

Global debt levels have been rising due to increased government spending in the wake of the Covid pandemic as well as longer term, powerful disruptive forces - called Megatrends - such as an ageing population, climate change, and global competition amid geopolitical tensions. Looking ahead, many governments are expected to continue spending more than they generate in revenue.

In the UK, weak growth and stringent fiscal rules have dented confidence in the government’s finances. Across the Atlantic, the “One Big Beautiful Bill Act” looks set to significantly increase spending in the US compared to revenues. The Congressional Budget Office (CBO) projects federal public debt will increase to 156% of US GDP by 2055.

Moody’s, the credit rating agency, downgraded the US from its top AAA rating to AA in response to the proposed increase in debt levels. The downgrade means the US lost its last top credit rating and contributed to another sell-off in global bond markets as investors weigh up mounting fiscal risks.
 
While the US is still able to service its debt, some are worried that bond investors might sell if they disagree with fiscal policies – as they did after Liberation Day on the 2 April. If many investors sell their bonds at the same time, it could make it harder and more expensive for the government to borrow money. In the extreme, this could lead to a debt crisis, where the government struggles to meet its interest payments, causing financial instability. This is an opportune moment to reflect on the implications for investors' portfolios.

Empirical research finds that the growing US deficit is likely to push long-term government bond yields higher¹. Increased federal spending without proportional revenue increases necessitates an increase in bond issuance. Even with extensive tariffs, the bill lacks significant revenue-raising measures.

As bond issuance rises, if investor demand doesn't keep up, the Treasury must offer higher interest rates, especially for longer-dated bonds where investors demand higher compensation for term risk (the uncertainty associated with holding bonds for a longer period). Additionally, new debt funding long-term projects can drive economic growth, raising expected inflation and pushing yields higher.

For many investors, bonds form a crucial part of their diversified portfolios. If long-term yields continue to rise in response to the growing debt burden, this could exert pressure on bonds.

The relationship between the growing debt burden and longer-term bond yields is not linear. Recent research finds that the extent to which yields are sensitive to increasing debt is influenced by the correlation between stocks and bonds (the degree to which stock and bond returns move together)¹. 

When stocks and bonds rise and fall together (positive correlation), investors are likely to demand higher compensation in the form of higher yields for holding bonds because they offer less protection during stock market downturns. 

Conversely, when stocks and bonds move in opposite directions (negative correlation), an increase in the supply of bonds could still result in lower yields given bonds are providing an additional diversification benefit by smoothing out stock fluctuations.

In recent decades, bonds have effectively hedged against downside equity risks, as seen during the Global Financial Crisis (GFC), when bond prices rose as equities tumbled. This crisis was a demand-side shock, which caused a drop in demand for goods and services. This led to falling yields and rising bond prices, causing a negative correlation between equities and bonds

However, this diversification benefit isn't guaranteed. Negative correlations have been common in recent history but prior to 2000, stocks and bonds moved together more frequently (positive correlation). 

The Covid pandemic, which caused a disruption in the supply of goods and services, shifted the correlation back to positive. Supply-side shocks cause surprise inflation and lower economic growth, depressing stock prices and increasing bond yields. This makes stocks and bonds positively correlated, and as a result, investors want higher returns on longer-dated bonds to compensate this². Despite fluctuations in their correlation with stocks, bonds are still able to provide some diversification benefits. Their regular income payments provide much needed stability during economic uncertainty.

These dynamics are particularly relevant during President Trump’s second term. A key promise of this administration is to crack down on illegal immigration. If successful, this would shrink the labour force (crucial to the supply side of the economy). The labour force would then have more bargaining power, potentially pushing wages up whilst reducing economic growth. Similarly, tariffs act as an import tax, which is frequently passed on to US consumers, raising prices and lowering growth. These supply-side shocks could present a challenge for both equities and bonds.

Conversely, depending on its final contents, the ‘One Big Beautiful Bill Act’ could represent a positive demand shock. Business-friendly policies coupled with tax cuts could boost both inflation and real GDP growth, which would be negative for bonds but positive for equities.

It's too soon to fully understand the impact the bill will have on the markets. Given this uncertainty, the best course of action is to stick to your long-term plan and stay invested in a diversified portfolio that is built to withstand an evolving market environment. 

Bonds remain a crucial component of well-diversified portfolios, offering predictable income and stability, especially during periods of heightened uncertainty. High-quality government bonds, like US treasuries and UK gilts, have a low risk of the government failing to repay its debt (default risk) and play an important role in capital preservation. Yields are currently at multi-decade highs, which means that bonds provide a relatively attractive 'risk-free' return. 

However, President Trump’s policies may reduce bonds' effectiveness as diversifiers due to potential supply-side shocks. Given this evolving macro environment, we hold exposure to alternative assets like gold, hedge funds and infrastructure to hedge against these risks.

At Evelyn Partners, we prioritise a well-rounded investment strategy. We build client portfolios designed to endure a range of economic scenarios, ensuring that we can deliver on your objectives without compromising on stability or growth potential.

Evelyn Partners offers combined wealth management services with professional advisers and investment managers who can help you work towards your financial objectives. To explore ways to balance your portfolio, please book an appointment or speak to your usual Evelyn Partners contact.

1. Ssrn.com, When is the supply effect large in the government bond market?, 6 November 2023
2. Campbell, J., Sunderam, A., and Viceira, L., Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds, February 2009.