Why the National Debt Matters for the U.S. Bond Market and the Economy

With $28.9 trillion in publicly held debt and an average of $910 billion in Treasury securities traded daily, the U.S. bond market underpins both domestic and global finance. Treasuries’ reliability, combined with the dominance of the U.S. dollar in international trade, has made them a foundational component of the global economy and among the safest and most liquid investments available to lenders worldwide.   

However, exploding public debt, recurring brinksmanship over the debt ceiling, and recent economic policy instability threaten to undermine confidence in the system. This uncertainty can push up Treasury yields, increase the share of taxpayer dollars paying down interest instead of paying for public programs, and increase borrowing costs across the entire economy.   

BPC tracks the interaction between U.S. fiscal policy, growing public debt, and the broader economy. This explainer describes how the bond market works, how it is evolving, and why it matters for the financial system. This explainer also considers how the market could react to continued high levels of borrowing with no meaningful plan for stabilizing an exploding public debt. 

What is the bond market?  

The U.S. bond market is where the federal government borrows to finance its operations. Each year, the Treasury conducts hundreds of auctions for debt of different maturities backed by the full faith and credit of the U.S. government: 

• Bills have terms as short as four and up to 52 weeks; 

• Notes have terms between two and 10 years; and 

• Bonds mature in 20 or 30 years. 

Decades of federal budget deficits have created an enormous market of publicly tradeable, low-risk securities. Debt held by the public is now $28.9 trillion—roughly the size of annual U.S. economic output—and growing. 

 Not all federal debt is publicly traded. An additional $7.3 trillion is held by other parts of government in the form of special nonmarketable securities—primarily trust funds like those for Social Security, Medicare, and civil service retirement systems. As these funds redeem assets to pay out benefits, the government often borrows from public markets, effectively converting this intragovernmental debt into public debt.  

Who buys public debt and why?

A wide range of investors buy U.S. debt: 

• The Federal Reserve buys and sells Treasuries for its monetary policy operations to influence interest rates, inflation, and employment.  

• Foreign governments and central banks hold Treasuries to manage their dollar reserves and currency exchange rates. The U.S. dollar has long been viewed as the world’s reserve currency, though that role is at risk of eroding. 

• Domestic and foreign private investors seek safe—and for some bond types, inflation-protected—investment assets. Foreign investors also hold Treasuries to increase their dollar holdings, which can be used to purchase U.S. goods, services, and other dollar-denominated assets. 

• Banks, state and local pensions, and private pension funds use Treasuries as a stable component of their overall capital management and investment strategies. 

Nearly one-third ($8.5 trillion) of U.S. public debt is held by foreign and international investors, about evenly split between private and government holdings. Japan ($1.1 trillion), China ($761 billion), and the United Kingdom ($740 billion) comprise the top three foreign holders of Treasuries—reflective of the size of their economies and trading ties with the U.S.  

What are yields, and how are they determined? 

Yields are the interest rates that investors receive in return for lending to the government, reflecting supply and demand in the bond market. Supply is driven by the rate of federal borrowing for both new deficits and to refinance maturing debt.  

Demand for Treasuries is influenced by expectations about economic growth and inflation, and confidence in the dollar and U.S. creditworthiness. Yields usually rise with elevated concerns about inflation or concerns about U.S. fiscal sustainability, as investors demand greater inflation-adjusted returns. They have typically fallen during recessionary periods as investors flock to the safety of Treasuries compared to more volatile assets.  

The Federal Reserve’s open market operations to set the federal funds rate and manage money supply also significantly influence yields. When the Fed buys large amounts of Treasuries to inject money into the economy, it increases demand and lowers yields. When it unloads its Treasuries to reduce the money supply and curb inflation, yields rise. 

How do Treasury yields relate to the broader economy? 

Treasury yields serve as an important benchmark for a wide range of borrowing across the economy. The interest rates faced by households, businesses, and state and local governments often move with Treasury yields of similar maturity. For example, mortgage rates closely track the 10-year Treasury yield, while auto loan rates track the yield on 5-year notes. Some rates are explicitly benchmarked to Treasury yields, including direct student loans and certain small business loans. 

Changes in interest rates shape activity across many sectors of the economy. Higher interest rates can push mortgages out of reach for potential homebuyers and make new housing developments less profitable for homebuilders. Small businesses like child care providers often rely on short-term credit to manage payroll and other operating costs, and rates can make or break profitability. Over time, elevated interest rates make it more difficult for businesses to expand and hire and for capital-intensive projects like new energy infrastructure, hospital systems, and research and development to procure financing.  

 

What role does fiscal policy play?  

All else equal, large federal budget deficits increase the supply of Treasury debt and put upward pressure on yields as investors demand higher returns to absorb additional borrowing. Fiscal policy also shapes investor expectations about future inflation, and evidence shows that bond markets effectively price in the deficit impacts of new legislation. Similarly, the Fed factors the impacts of fiscal policy into setting the federal funds rate, which as mentioned holds enormous influence over other rates across the economy. 

Investor confidence in the government’s ability to faithfully repay its debts also moves yields. For example, debt limit brinksmanship leads investors to demand higher yields due to the heightened possibility of default. Such uncertainty undermines public confidence in Congress’s willingness to function and the government’s ability to steward its debts. The 2023 debt limit episode led to a record 5.84% yield on 4-week securities, the highest auction yield since 2000.  Downgrades of the U.S. sovereign credit rating by S&P and Fitch reflect this lowered confidence and signal concerns about long-term fiscal trends.  

What are the consequences of rising debt? 

Since 2020, rising yields combined with ballooning deficits significantly spiked interest costs for taxpayers and the federal government. Nearly $1 of every $5 in federal revenues goes toward interest on the debt, and net interest is now the second-largest government expenditure. These payments are projected to grow by 6.5% annually from fiscal years 2025 to 2035, which would likely squeeze the government’s ability to invest in other public priorities. 

 

The path of the national debt therefore holds consequences for the real economy. The Congressional Budget Office estimates that a 1 percentage-point increase in the projected ratio of debt-to-gross domestic product raises average long-run interest rates by 2 basis points. Increased government borrowing, with rising yields, competes with private demand for capital, “crowding out” productive private investments by about 33 cents per dollar. Over time, reduced private investments erode U.S. economic competitiveness.  

The reverse is true, too: credible efforts to stabilize and reduce the national debt can ease borrowing costs for families and businesses. Putting the budget on a fiscally sustainable path can bolster confidence in U.S. bonds as a stable and secure investment, ease concerns about future inflation, and strengthen the foundation for durable economic growth.