A New Era of Fiscal Risk
America’s public debt is soaring, deficits remain uncontained, and for the first time in history all three major credit rating agencies have downgraded U.S. sovereign debt below AAA. The U.S. fiscal position, once a background concern, has become more central to financial markets. While there is no imminent crisis, the long-term consequences of sustained borrowing and political inaction are beginning to reshape the landscape for investors, policymakers, and the global economy.
Table of Contents:
- Debt and Deficits: A Structural Problem
- Credit Downgrade: Symbolism and Signal
- Market Reactions and Risks
- Why Deficits Matter More Than Ever
- Investment Implications in a High-Debt World
- The Clock Is Ticking
Debt and Deficits: A Structural Problem
As of mid-2025, the U.S. federal debt has reached an all-time peacetime high of $36 trillion, equivalent to over 120% of GDP. Publicly held debt is projected to exceed the size of the economy in 2025, a trajectory that economists agree is unsustainable.
In a healthy fiscal environment, deficits typically shrink during economic expansions. But in FY2024, the U.S. ran a $2 trillion deficit—approximately 6.7% of GDP—even with unemployment under 4%. This indicates a structural imbalance: government expenditures are consistently outpacing revenues regardless of the economic cycle.
Rising interest rates have tripled the government’s interest payments since 2017. In FY2024, net interest outlays hit $879 billion, surpassing national defense and Medicaid. Projections suggest that interest payments could exceed $1.5 trillion annually by 2034, consuming as much as one-third of all federal revenue.
Credit Downgrade: Symbolism and Signal
Heading into 2025 two out of the three major credit rating agencies downgraded the U.S. credit from its pristine AAA rating.
On May 16, 2025, Moody’s downgraded the U.S. sovereign credit rating from AAA to Aa1, following S&P (2011) and Fitch (2023). This marks the first time the U.S. has lost its top credit rating across all three agencies. Moody’s cited “persistent large fiscal deficits” and “growing interest costs” without a credible plan to address them. Political gridlock and the potential extension of the 2017 tax cuts, which could add $4 trillion to the debt over the next decade, were major concerns.
This downgrade underscores a growing consensus that the U.S. fiscal trajectory is on an unsustainable path. The combination of high debt, rising interest costs, and political stalemate has been eroding confidence in America’s long-term creditworthiness.
Market Reactions and Risks
The immediate market response to the downgrade was mild, yields on U.S. Treasurys rose slightly but stabilized. The stock market reacted similarly to this news with an initial sell off, followed by a strong recovery.
While markets have largely shrugged off the downgrade in the short term, over time, a lower credit rating could lead to higher borrowing costs as investors demand compensation for perceived fiscal risk. This could lead to some headwinds to markets over the longer term.
Additionally, this downgrade is having an impact on the “safe haven” image of U.S. debt. Currently U.S. debt remains the global benchmark, however, the loss of AAA status has psychological and practical implications. Some ultra-conservative investors and central banks, especially those with mandates to hold only top-rated assets, may begin to diversify away from Treasurys. Indeed, global central banks have already started doing just that: in 2022 and 2023, they bought over 2,000 tons of gold, a historic high, partly as a hedge against U.S. fiscal risk. In 2025, gold prices surged past $3,100/oz, reflecting strong safe-haven demand.
These high debt levels also constrain Washington’s ability to respond to future emergencies. In a downturn, fiscal space, the ability to borrow without spooking markets is far more limited than it was during the 2008 crisis or the COVID-19 pandemic.
Why Deficits Matter More Than Ever
The End of the “Free Money” Era
For much of the 2010s, the United States operated under what some dubbed the “free money” regime, ultra-low interest rates and subdued inflation made borrowing inexpensive and deficits relatively benign in practical terms. At times, the government paid less than 2% on long-term debt, allowing trillions in borrowing with limited fiscal consequences.
However, that period has ended, from 2022 to 2024, interest rates rose sharply as the Federal Reserve fought inflation, and with them, the cost of carrying federal debt has skyrocketed. The average interest rate on federal debt doubled from approximately 1.5% to 3% and continues to climb. As low-rate bonds issued in previous years mature and are refinanced at higher rates, the government's interest bill is compounding.
In FY2024, net interest costs surged to $879 billion, a 35% increase year-over-year. That figure now exceeds spending on national defense and rivals several key entitlement programs. Looking forward, interest costs are projected to reach $1.5 trillion annually by the early 2030s, potentially consuming up to one-third of all federal revenue.
In this new environment, deficits no longer seem painless. They have become a major budgetary burden and a growing one.
Deficits Are Structural, Not Cyclical
One of the most troubling aspects of the U.S. fiscal picture is that today’s deficits are not the result of temporary shocks or economic downturns. They are structural, embedded in the underlying gap between what the government spends and what it collects.
This is evident in the data: in FY2024, despite strong GDP growth and unemployment under 4%, the federal deficit still came in near $2 trillion, or 6.7% of GDP. That is nearly triple the historical average for a non-recession year (roughly 2.4% of GDP).
What’s driving this? A few key factors:
- Entitlement Spending: Programs like Social Security, Medicare, and Medicaid are growing rapidly due to an aging population and rising healthcare costs. These "mandatory" outlays now account for nearly two-thirds of all federal spending.
- Revenue Shortfalls: The 2017 Tax Cuts and Jobs Act reduced corporate and individual tax rates, and other measures have eroded the tax base. Revenues as a share of GDP remain below pre-2017 levels.
- Defense and Discretionary Spending: Despite calls for fiscal discipline, defense budgets have risen, and new discretionary initiatives from infrastructure to pandemic relief have added to the spending baseline without matching revenues.
Without policy reforms, these imbalances will persist, and worsen, as demographic and interest cost pressures mount.
Deficits Are Now Fueling Interest on the Deficits
There is a compounding dynamic at play: large deficits require borrowing; that borrowing drives up interest costs; those interest costs create even larger deficits. This feedback loop is particularly dangerous at today’s scale of debt.
Consider this: for every 1% rise in interest rates, the government’s annual interest bill increases by roughly $300 - 400 billion over time. As of 2025, total debt exceeds $36 trillion, meaning small rate changes now have massive budget implications. This is why rising interest rates and persistent borrowing have created a new urgency. The math no longer works unless fiscal adjustments are made.
Crowding Out and Diminished Flexibility
In a high-debt, high-interest environment, every dollar spent on interest is a dollar not available for critical investments in infrastructure, defense, education, or economic stimulus.
More troubling, the government’s ability to respond to future emergencies is constrained. When COVID-19 struck in 2020, the U.S. borrowed trillions without damaging confidence. But with debt now over 120% of GDP, the “fiscal space” to act decisively in the next crisis is limited. Markets may react more harshly if new borrowing appears excessive or destabilizing.
In the long run, unchecked deficits risk crowding out private investment as heavy government borrowing competes for capital, potentially raising interest rates across the economy.
Political Paralysis Is Amplifying the Risk
Deficits are not destiny, but political dysfunction can make them feel that way. Despite repeated warnings from economists and rating agencies, Congress has failed to pass any serious long-term plan to stabilize the debt trajectory.
The pending expiration of the 2017 tax cuts in 2025 presents an inflection point. Extending them, as some propose, could add $3 - $4 trillion to the debt over the next decade. At the same time, there is little appetite for entitlement reform or large-scale spending reductions.
This gridlock is part of what led Moody’s to downgrade the U.S. credit rating in 2025. As their report stated, “successive U.S. administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs.”
It’s Not the Absolute Debt—It’s the Trajectory
Federal Reserve Chair Jerome Powell put it succinctly: “It’s not any specific dollar level that’s the issue, it’s the path.” Economies can support high debt levels if they’re stable or shrinking relative to GDP. But when debt grows faster than the economy year after year, it becomes unsustainable.
Without intervention, the debt-to-GDP ratio is projected to exceed 130% by the mid-2030s, a level historically associated with slower growth, higher interest rates, and increased risk of financial instability.
Investment Implications in a High-Debt World
The U.S. fiscal trajectory is no longer just a concern for policymakers; it is a growing market variable with direct and indirect effects on investor portfolios. From interest rates to inflation hedges to asset correlations, a sustained high-debt environment is reshaping the investment landscape. This evolving fiscal backdrop could affect capital markets and portfolio strategies in several important ways.
Higher Baseline Interest Rates and Yield Volatility
One of the most immediate effects of persistent deficits is upward pressure on interest rates. When the Treasury issues trillions in new debt annually to finance budget shortfalls, it increases the supply of bonds in the market. If demand does not keep pace, especially in the wake of credit downgrades, yields must rise to attract buyers.
- Supply - demand imbalance: The U.S. Treasury now issues over $2 trillion in net new debt annually. At the same time, major foreign holders like China and Japan have slowed their Treasury purchases, and the Federal Reserve has shifted from buying to shrinking its balance sheet (quantitative tightening).
- Rising term premiums: Investors may now require a higher risk premium to lend long-term to a government with fiscal stress. This helps explain why the 10-year Treasury yield climbed above 5% in 2023, a 16-year high.
- Portfolio consequences: Higher yields mean new bonds offer better returns, which is good for future income generation. However, rising rates erode the value of existing bonds, contributing to the sharp fixed-income losses seen in 2022 and 2023. Investors must be nimble in managing duration and interest rate risk.
Equity Market Pressure from Rate Sensitivity
Higher interest rates tend to compress equity valuations through several mechanisms:
- Discount rate effect: Future corporate earnings are valued less when discounted at higher rates, particularly impacting growth stocks and tech companies with long-duration cash flows.
- Cost of capital: As borrowing becomes more expensive, corporations may delay capital investment or face margin pressures from higher interest expenses.
- Market volatility: Fiscal-driven swings in Treasury yields can introduce unexpected turbulence to equity markets, particularly around budget battles, debt ceiling showdowns, or inflation scares.
While equities remain a core long-term asset class, investors should expect more frequent episodes of fiscal-driven volatility and potentially lower valuation multiples than those seen in the ultra-low-rate 2010s.
Breakdown of the Stock–Bond Hedge Relationship
Traditionally, bonds have served as a natural diversifier in balanced portfolios. When equities fell, Treasury prices typically rose (yields dropped), providing ballast during market downturns. However, that relationship broke down in 2022–2023 when both stocks and bonds declined sharply—a scenario many attributed to inflation fears and rate hikes.
In a high-debt, high-inflation risk world:
- Correlation convergence: If fiscal policy remains loose and inflation risks persist, investors could face situations where stocks and bonds fall simultaneously, especially if rate hikes are required to maintain price stability.
- Diversification rethink: This weakens the case for the traditional 60/40 portfolio and emphasizes the need for alternative diversifiers, such as commodities, floating-rate debt, infrastructure, or absolute-return strategies.
Renewed Focus on Inflation Hedges and Real Assets
Deficits can indirectly fuel inflation if they lead to excessive monetary accommodation or trigger concerns about long-term fiscal dominance. While the U.S. is not currently “monetizing the debt,” the sheer scale of government borrowing raises questions about how future obligations will be financed.
Markets are already responding:
- Gold: Central banks and investors have increased gold allocations. Global gold purchases exceeded 1,000 tons annually in both 2022 and 2023. Prices hit record highs above $3,100/oz in 2025, in part due to fiscal and geopolitical hedging.
- TIPS: Treasury Inflation-Protected Securities offer a government-backed way to protect against rising prices and have regained attention as inflation risks re-enter the investment conversation.
- Real estate & infrastructure: Hard assets that generate income linked to inflation or economic growth can serve as long-term hedges.
- Commodities and energy: Energy, metals, and agriculture exposure can provide both inflation protection and diversification, though they come with cyclical and geopolitical risks.
A strategic allocation to real assets and inflation-sensitive securities may be more important in the decade ahead than in the last one.
Credit Spreads and Corporate Borrowing Risk
A downgrade to the U.S. sovereign credit rating can have spillover effects on private credit markets:
- Benchmark shifts: Treasurys are the risk-free benchmark for virtually all credit pricing. A rise in Treasury yields increases corporate borrowing costs even if spreads remain stable.
- Spread sensitivity: Fiscal deterioration could indirectly widen credit spreads, especially for lower-rated corporate and municipal bonds, as investors reevaluate systemic risk.
- Municipal bonds: While often seen as a safe haven, state and local governments may face greater scrutiny in a world of higher federal debt and reduced federal fiscal support.
Credit selection and risk-adjusted analysis will be increasingly important in fixed-income allocations.
Currency and Global Diversification Considerations
Heavy U.S. borrowing, when combined with monetary easing or debt monetization, can lead to dollar weakness over time. While the U.S. dollar remains dominant in global trade and reserves, fiscal concerns may encourage diversification by foreign investors and central banks.
- Gold and currency reserves: As noted, central banks are gradually shifting reserves from dollars to gold and other currencies.
- Emerging markets: Some investors may increase exposure to countries with healthier fiscal profiles or stronger structural growth.
- Currency hedging: U.S.-based investors may need to consider FX risks in international portfolios, and vice versa.
The Clock Is Ticking
America’s fiscal health is not in crisis, but it is in question. The loss of AAA status across all three rating agencies is more than symbolic: it is a warning that even the world’s largest economy cannot defy financial gravity forever.
In this new environment, fiscal risk has become an investment variable. Government borrowing, once a benign background condition, now influences interest rates, asset correlations, inflation expectations, and even investor psychology.
For asset managers and individual investors alike, the implications are profound:
- Interest rates may stay higher for longer.
- Traditional diversification strategies may prove less reliable.
- Inflation hedging and real assets deserve renewed focus.
- Volatility around policy decisions and debt management will remain elevated.
The solutions: spending reform, revenue enhancement, and economic growth are known. What’s lacking is political consensus. For investors, this means staying informed and prepared. For policymakers, it means acting before market forces impose a solution of their own.
The era of “deficits don’t matter” is over. The era of fiscal reckoning has begun.
Not an offer: This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact Instrumental Wealth or consult with the professional advisor of their choosing. Forward-looking statements: Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future. Past Performance: There is no guarantee that the investment objectives will be achieved. Moreover, the past performance is not a guarantee or indicator of future results.
Certain information contained herein has been obtained from third party sources and such information has not been independently verified by Instrumental Wealth LLC. No representation, warranty, or undertaking, expressed or implied, is given to the accuracy or completeness of such information by Instrumental Wealth LLC. or any other person. While such sources are believed to be reliable, Instrumental Wealth LLC. does not assume any responsibility for the accuracy or completeness of such information. Instrumental Wealth LLC. does not undertake any obligation to update the information contained herein as of any future date