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Spending battles putting national debt in jeopardy

Solid fiscal plan, increased budget caps wanted to keep federal deficit from getting out of control

Marc Goldwein said debt will account for more than 100% of GDP by the end of the decade.

An already high national debt that is expected to grow by $1 trillion or more as tax reform takes hold over the next decade has investors closely watching as Congress races to pass spending bills and prevent a government shutdown by Jan. 19.

In theory, lower federal tax receipts from the recent reforms that increase the federal deficit should prompt more debt issuance that would lower Treasury bond prices and push up yields, while a rising debt level could also push long-term yields higher. Yet many market watchers believe the market already has priced in the prospect of a rising national debt, and are not too concerned, unless Congress keeps stalling and getting the U.S. government closer to a debt ceiling impasse.

"Demand for U.S. Treasuries is still strong. The big impact is just this environment of uncertainty and how it impacts business," said Hussam Syed, senior managing director and portfolio manager at Sun Life Investment Management in Wellesley, Mass., which has $44 billion under management. "From an investor perspective, it is making it difficult for companies to do long-term planning."

The first challenge for Congress this year is striking a deal on federal spending for the rest of fiscal year 2018 and increasing budget caps to avoid automatic across-the-board spending cuts, known as sequestration. The sequestration level caps, which are supposed to curb tendencies to spend more on defense and non-defense items, also help to control deficits somewhat, or at least help offset spending hikes with cuts or federal revenue increases.

Congress is already on its third temporary spending measure for the fiscal year that began Oct. 1. Now they have to work to avoid a Jan. 19 shutdown. With the House of Representatives not back in session until Jan. 8, the prospect of yet another temporary stopgap is considered likely while the standard 12 appropriations bills that fund the federal government are readied for floor votes.

Then there is the estimated $1 trillion added to the national debt as a result of tax reform, plus other pressing legislative needs like disaster relief that Congress cannot push down the road. Between the raised spending caps, disaster relief and some other necessary tax extenders, debt will account for more than 100% of GDP by the end of the decade, said Marc Goldwein, senior vice president and senior policy director for the non-partisan Committee for a Responsible Federal Budget in Washington. "We are headed toward debt being higher than it ever was before," said Mr. Goldwein, who calls fiscal hawks ​ "an endangered species."

One possible silver lining is "if things get so bad, maybe people will wake up," he said, referencing 1982, when a series of tax cuts in previous years added too much to the deficit and had to be trimmed back.

Until then, though, "I think there are a lot of investors of the view that someone's going to fix it at some point. Maybe they are misunderstanding how long it takes to fix. It counts on a functional political system."

While the U.S. could "stumble along" with lower economic growth, "it's not too hard to imagine (a scenario) where markets got scared, and demanded higher interest rates, and they are going to sell off those bonds.

"We are no longer a medium-debt country. We have a lot of things going for us but if things go bad, they could go really bad," said Mr. Goldwein.

Mr. Syed of Sun Life Investment Management thinks that relaxed views on the deficit could change if expected economic growth does not materialize: "At some point that confidence will take a hit." Having the ratio of debt to GDP grow "is definitely a risk. It does not take a lot for the sentiment to change," he said.

While investors might be less than alarmed about the level of federal debt now, things will get more interesting in February, when the Treasury Department issues its quarterly refunding report. That announces what it needs for the next two quarters to fund the debt, and gives investors signals about the supply and potential yields, while also getting input from market participants on how the debt should be funded.

Members of the Federal Open Market Committee worried at their December meeting about potential changes to the slope of the yield curve, and whether the possibility of short-term yields rising above those on longer-term Treasury securities — an inversion — would portend an economic slowdown.

Aaron Anderson, senior vice president of research at Fisher Investments in San Francisco, a long-equity manager with $95 billion in assets under management, thinks that while deficit talk can affect investor sentiment, "when you look at the empirical evidence, there's scant evidence that it will have an impact on the near-term market.

"The historical perspective is very useful. From a broader economic perspective, there's always a deficit. People get worried about that but if you look at the impact on the economy and the market, it really is nil," said Mr. Anderson.