Debt Concerns Come Into Focus as Spending Bill Advances

Equities fell and bond yields rose last week as investors turned their attention to the U.S. deficit and received a reminder late in the week that trade policy and tariff negotiations remain in flux.

Negotiations on a Republican-backed spending bill that included many of President Trump’s priorities drove the market for much of the week. The bill, which was approved by the House of Representatives last week and now goes to the Senate, by some estimates is expected to add a net $2.3 trillion to the federal debt over the next 10 years, according to preliminary analysis from the Congressional Budget Office. The projected cost of the bill reignited concerns about the size of the U.S. debt and its potential impact on the economy and interest rates. Indeed, there was weak demand last Wednesday at an auction for 20-year Treasurys, which led to a rise in yields as investor concerns grew about U.S. debt levels and weakening demand for U.S. debt.

During the past 20+ years, both parties have added to the Federal debt, which rose from $8.1 trillion in 2005 to $36.3 trillion in 2024. Meanwhile, as interest rates have risen, so have the costs associated with servicing the debt. Interest payments on the debt now run nearly $1 trillion per year, making debt servicing the second biggest expenditure by the federal government (behind Social Security payments). This trend is expected to continue, as the average interest rate on current outstanding federal debt was 3.35 percent as of April, which is below what short-, intermediate- and long-term Treasurys are currently yielding. That means that as existing Treasurys mature and are replaced with new bonds, the interest costs will increase on the refinanced balance.

Rising interest costs increase economic risks and can reduce the Federal government’s ability to respond to an economic downturn. Indeed, the risk caused by higher interest costs is why the administration has been focused on yields on intermediate-term Treasurys. Currently, 10-year Treasurys yield about 4.6 percent, which is little changed from the 4.61 percent they yielded at the end of May 2024. However, the current yield is above the 3.99 percent they were yielding as recently as the first week of April of this year and well above the recent low of 3.61 percent recorded on September 16, 2024—two days before the Federal Reserve made its first rate cut of this easing cycle.

It’s worth noting that many had anticipated that a cut in the Fed funds rate would result in a drop in yields for longer-term Treasurys. The recent climb in yields likely reflects concerns about a potential rise of inflation as a result of tariffs as well as concerns that the U.S. will need to pay higher interest rates on bonds as more U.S. debt comes to market, coupled with potentially less foreign demand. The U.S. is not alone in seeing yields on its sovereign debt rise. In the United Kingdom, yields on 30-year sovereign bonds recently rose to the highest level since 1997. Similarly, Japan saw yields on its 30-year bonds touch an all-time high recently as its latest inflation reading came in higher than expected. Put simply, rising yields on sovereign debt around the globe have the potential to put upward pressure on yields for U.S. Treasurys in the coming years.

The economic risks associated with higher interest rates were also reflected in equities last week as stocks slid as yields rose. The decline for equities broke a four-week winning streak for the S&P 500 that started shortly after President Trump paused reciprocal tariffs on virtually all U.S. trading partners. The pause—along with a temporary reduction on levies between China and the U.S. as well as an agreement on a framework trade deal with the United Kingdom in recent weeks—had left many to conclude that the bulk of uncertainty on the trade front was over. However, last week Trump suggested that the U.S. should initiate 50 percent tariffs on goods from the European Union and an additional 25 percent tax on Apple iPhones produced outside the U.S. Over the weekend, the administration announced that it wouldn’t implement the new tariffs on the EU until July 9. Still, the announcements served as a reminder that negotiations with global trading partners are not yet settled, and volatility from trade policies as the 90-day pause on most tariffs continues could reemerge at any time.

All this occurred during a week in which more soft data suggested the economy may be headed for a slowdown. While hard data has been resilient, we believe that the impact of tariffs and general economic uncertainty may begin to show up in the coming months. Until it does, we believe the Federal Reserve will hold rates steady as it waits to see the impact policy changes will have on prices and the job market.

As we’ve frequently noted in our recent commentaries, our discussions of the risks associated with the administration’s efforts to reconfigure the global economy are not meant to pass judgment on specific policies. Instead, we are focused on the potential risks we believe investors should be aware of in the current environment. We also believe it is important to keep in mind that risk and uncertainty in the markets are always present to some degree. That said, the macroeconomic winds have shifted, and we believe they will favor different asset classes moving forward. For more information on this topic, check out our recent Quarterly Market Commentary and Asset Allocation Focus.

Wall Street wrap

As we continue to focus on signs of how recent changes in economic policy will affect hard economic data, last week brought more signs that trade policy, higher interest rates and elevated uncertainty are making an impact on the soft data.

Pace of economic growth increases as prices spike: Preliminary data from the latest S&P Global Purchasing Managers Index (PMI) showed that the pace of growth quickened in May, with both services and manufacturing activity accelerating. The latest preliminary data, which tracks both the manufacturing and services sectors, shows that the Composite Output Index came in with a reading of 52.1 (levels above 50 signal growth), up from April’s final reading of 50.6.

Manufacturing PMI came in at 52.3, up 2.1 points from April and the highest level in three months. The Manufacturing Output Index rose 1.1 points to 0.7. It’s worth noting that the increase in manufacturing was driven by stocking of inventories, which saw the greatest increase in the history of the survey dating back to 2009; the stockpiling of inventory could be a sign of customers buying ahead of expected price increases tied to tariffs. Meanwhile, the Services Business Activity Index rose to 52.3, up 1.5 points from April. Although readings for both manufacturing and services are at expansionary levels, the pace of growth is subdued by historical standards.

New orders rebounded for both sides of the economy; however, demand for services exports, which includes demand from foreigners visiting the U.S., declined. As a result, the rebound in demand for services was modest, regaining levels last seen in March. Manufacturing saw a robust uptick in sales, with new orders rising at the fastest pace in 15 months.

Prices charged by both sides of the economy jumped, with manufacturers raising prices at the fastest rate since August 2022. The pace of price increases from service providers rose at the fastest pace since April 2023. The increase in output prices was closely tied to tariffs, as the levies drove up the cost of imported inputs or caused suppliers to pass along tariff-related cost increases. Manufacturing input costs accelerated at the fastest pace since August 2022, while costs for services increased at the sharpest rate since June 2023.

The rise in input costs and bottlenecks in supply chains due to tariffs could result in higher prices for consumers in the near future. “Supply chain delays are now more prevalent than at any time since the pandemic led to widespread shortages in 2022, and prices charged for both goods and services have spiked higher as firms and their suppliers seek to pass on tariff levies to customers. The overall rise in prices charged for goods and services in May was the steepest since August 2022, which is indicative of consumer price inflation moving sharply higher,” Chief Business Economist of S&P Global Market Intelligence Chris Williamson noted in comments released with the report.

Forward-looking indicators fall sharply: The latest Leading Economic Indicators (LEI) report from the Conference Board weakened but stopped short of signaling a recession. The April LEI reading fell 1 percent after March’s final reading showed a decline of 0.8 percent. The size of the monthly decline is the largest since March 2023, when many (including us) thought the economy was headed toward a recession. The anticipated economic contraction never came to pass. The reading is now down 3.9 percent on an annualized basis over the past six months, weaker than the six-month annualized decline of 2.5 percent reported in March. The six-month diffusion index (the measure of indicators showing improvement versus declines) faltered, registering 35 percent, well off from last month’s 70 percent reading. For the second consecutive month, a downturn in consumer expectations weighed most heavily, followed by a decline in the stock market and weaker new orders for manufacturers. While recent deterioration in the measure is not yet flashing warning signs of an approaching recession, “the Conference Board currently forecasts U.S. real Gross Domestic Product to grow by 1.6 percent in 2025, down from 2.8 percent in 2024, with the bulk of the impact of tariffs likely to hit the economy in Q3,” Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted in remarks released with the report.

Existing home sales drop again as inventory expands: The National Association of Realtors (NAR) reported that existing home sales in the U.S. fell 0.5 percent in April to a seasonally adjusted annual rate of four million units. The pace marks the lowest total on record for the month of April since April 2009. Wall Street forecasts had called for a rise in sales. With the monthly decrease, sales were down 2 percent from year-ago levels, marking the third consecutive month of year-over-year declines. The inventory of available homes grew by 9 percent in March to 1.45 million units, or about 4.4 months of supply.

The recent trend of rising inventories has yet to make a meaningful impact on prices. The median price for existing homes came in at $418,000, up from the prior month and 1.7 percent higher than in April 2024.

High mortgage rates and rising prices continue to weigh on sales. Interest rates are lower than year-ago levels but have been trending higher of late. In comments released with the latest report, NAR Chief Economist Lawerence Yun said, “Pent-up housing demand continues to grow, though not realized. Any meaningful decline in mortgage rates will help release this demand.”

The near-term outlook for a drop in rates is dim. Yields on 10-year Treasurys, which are closely tied to mortgage rates, have been trending higher, and mortgage rates are hovering near three-month highs.

Continuing jobless claims rise: Initial jobless claims were 227,000, a decrease of 2,000 from the prior week’s final figure. The four-week rolling average of new jobless claims came in at 231,500, up 1,000 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.9 million, up 36,000 from the previous week’s revised total. The four-week rolling average of continuing claims came in at 1.887 million, an increase of 17,500 from last week. As we’ve noted in prior commentaries, we believe continuing claims are a more reliable indicator of the labor market, as they measure workers who are facing long-term challenges in finding a job and, as such, filter out some of the temporary noise that can be found in initial claims data.

The week ahead

Tuesday: The Conference Board’s Consumer Confidence report for May comes out in the morning. Last month’s report showed a drop in confidence. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges in finding work. We’ll also be looking for signs about how consumers are feeling about their financial prospects and the expected pace of inflation going forward.

Data on durable goods orders for April will be released to start the day. We’ll be watching for signs of the direction of business spending in light of signs of growing uncertainty and slowing economic growth.

We’ll be watching the S&P CoreLogic Case-Shiller Index of property values covering March. Prices overall have moved higher, albeit at a slower pace, in the past several months. We will be looking to see if home prices continue to rise.

Wednesday: The day offers a look at the minutes from the most recent meeting of the Federal Reserve Board. We’ll be looking for board members’ thoughts on the balance of risk between the two sides of its dual mandate of full employment and price stability. We’ll also be looking for any comments on the expected impact tariffs will have on inflation and Fed policy going forward.

Thursday: The Bureau of Economic Advisors will release its second estimate of gross domestic product (GDP) growth for the first quarter. The first estimate showed that GDP unexpectedly shrank during the first quarter due largely to an increase in imports. We will be watching for any significant revisions to the first estimate.

Friday: The April Personal Consumption Expenditures Price Index from the Bureau of Economic Analysis will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making interest rate decisions. We’ll be monitoring to see if the latest data shows additional signs of progress in the disinflation process or if tariffs are beginning to show up in inflation readings.

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