Market Commentary: Deficit Attention Disorder

The U.S. government’s fiscal health, or lack thereof, has suddenly become a topic of concern that is spreading across the country like a new strain of flu. What finally dragged the topic into public consciousness was sharply higher interest rates. Remember that, for most of the past two and a half years, investors have been pinning their hopes for a healthy stock market on future Federal Reserve (Fed) rate cuts and presumably lower interest rates that would follow. That prescription clearly has failed. In many of my articles over the last year and a half, I have included the caveat “Watch the yield on the 10-year Treasury notes.” My concern was that our government’s huge fiscal deficits and massive debt would eventually begin to put upward pressure on interest rates, and that the Fed, which can influence short-term rates, would be powerless to prevent higher long-term yields. My corollary concern was that higher rates would then slow economic growth and weigh on equity valuations.

Long-term Treasury yields have climbed significantly in that time despite the Fed cutting its target overnight lending rate from 5.375% to 3.625%. The 10-year yield, which was at 3.6% two years ago, when the Fed first reduced its target rate, is now hovering near 4.7%. Yet stock indices are near all-time highs. That strong equity performance during a period of rising interest rates can be ascribed to a combination of circumstances. First, corporate earnings growth has been very strong. The composite earnings per share of the S&P 500 (SPX) stocks have climbed from about $244 in 2024 and $271 in 2025 to an estimated $359 this year and something around $407 for next year.

Second, it was easy to find several nonfiscal excuses on which to blame the higher rates: One, higher energy prices meant higher expected inflation, which in turn led to higher bond yields. Two, central banks around the world were increasing their interest rates, which was a tailwind for rates here. Three, earlier this year, several mega-cap tech companies issued hundreds of billions of dollars in new long-term debt to help finance their huge ongoing capital expenditures. That added significant new supply to the bond market. A fourth factor lifting rates became more evident over the past month or two: The Fed is very unlikely to cut its target rate this year and is now expected to actually hike the rate later this year. Following Fed Chair Kevin Warsh’s press conference in the prior week and his Jackson Hole address last Friday, the futures market is currently indicating about a 60% probability of a Fed rate hike next month, and more than an 80% chance for a rate hike before year end.

All those factors are still present; what’s new is that there now seems to be official concern about the higher rates and how they are exacerbating the deficit problem. With outstanding debt of about $40 trillion, each quarter-point increase in the average cost of financing that debt increases the debt service expense by $100 billion per year. About two weeks ago, as the long-bond yield hit its highest level since 2007, Treasury Secretary, Scott Bessent, made an attempt to thwart that advance. He announced that his department would increase the size of its long-term bond buyback program, from $2 billion to $4 billion per operation from early September until early November (the day after Election Day). The intervention was intended to reverse the uptrend in Treasury yields. But while long-term yields dropped immediately and significantly on the announcement, the action failed to reverse the trend. Long yields recovered all of their declines the very next day.

Last week, The Wall Street Journal, in its op-ed column, ran a letter from a well-known fund manager, Stanley Druckenmiller, titled “Let the Bond Market Speak” with a tagline “Rising interest rates are a signal of trouble ahead. Artificially suppressing them heightens the danger.” Suffice it to say that the article presents many good points. My conclusion is that Mr. Druckenmiller feels that short-term gimmicks to suppress long-term yields will not provide more than temporary relief and instead will just delay taking any steps to actually address the debt and deficit. In his words, “Governments defending prices against fundamentals always lose.”

While the increase in long-term interest rates has been persistent, it has also been gradual. Perhaps the recent signs of a weakening labor market, a slowing housing market and a leveling off of crude oil prices will be sufficient to stall the upward march of long-term interest rates. Even if rates quietly tiptoe a bit higher, it would likely have little impact on the stock market. But take note if long-term rates and interest rate volatility spike higher. The stock market would probably respond poorly to a shock of higher rates and higher rate volatility.

The debt and deficit were of little concern last week. SPX advanced 0.49% and is now up 12.65% year to date (YTD). The NASDAQ Composite Index (COMP) added 0.85% for the week and boosted its YTD return to 13.6%. Both indices saw their highs of the week on Thursday following a bullish reaction to a very positive earnings report from NVIDIA Corp. (NVDA). Communication services (XLC, +1.43%) and technology (XLK, +1.30%) led the U.S. equity sectors. Of the other nine sectors, only financials (XLF, +1.08%) managed to come through the week with a net gain. The resurging healthcare sector was the worst of the eight losing sectors, falling 1.98%.

The communication services and technology sectors account for nearly 50% of the component weight of SPX. So it’s no surprise that SPX had a decent week. But the negative bias of the performance of the other sectors hints at weakness below the surface. The equal-weight version of the S&P 500 lost 0.46% last week. The Russell 2000 Index of small-cap stocks fell 1.51%; the S&P Small-Cap Index lost 1.22% and the mid-cap index slid 1.33%. For the second week in a row, the New York Stock Exchange had more declining issues for the week than advancers.

Several software companies led the S&P stocks last week. Salesforce Inc. (CRM, +22.39%), CrowdStrike Holdings, Inc. (CRWD, +13.78%) and ServiceNow Inc. (NOW, +12.63%) have all been rebounding over the past month. While CRM and NOW still have low single-digit net losses for the year, CRWD is now showing a YTD gain of more than 86%. Both CRM and CRWD released their second-quarter earnings last Wednesday. The two biggest losers among the S&P stocks were PayPal Holdings Inc. (PYPL) and Generac Holdings Inc. (GNRC). PYPL lost nearly 13% for the week and is now down 8.08% YTD. All of that loss came on Friday following news that a takeover attempt by a private equity firm had been abandoned. GNRC fell another 10.77% last week and is now nearly 40% below its high about two months ago.

The second-quarter earnings season is winding down. The flood of announcements earlier this month is tapering to just a trickle. High-profile companies due to report this week include Dell Technologies and Palo Alto Networks on Tuesday, along with Broadcom and Snowflake on Wednesday. The economic reports with the greatest potential to roil the markets this week are the employment reports late in the week.

Learn more about Benjamin F. Edwards.