By KFI Staff
U.S.’s “Unsustainable” Deficit Financing Forces Rates Higher
Long-term yields on U.S. Treasury (UST) bonds scorched higher last week, with the rate on the 10-year reaching a three-month high near 4.63% and the 30-year breaching 5.15%—its highest level in over a year and a half. This move was largely inspired by the U.S. receiving its second credit rating downgrade in less than two years and comes amid fears that a new budget reconciliation bill in Congress—featuring significant tax and spending reforms—might further expand the nation’s ballooning deficits.
The U.S. fiscal deficit widened to $1.8 trillion in 2024, marking the third-largest annual shortfall in history and an 8.1% year-over-year (YoY) rise. This deficit is being supercharged by expenditures on mounting interest payments, which recently surged to a record $1.1 trillion in 2024. The term “unsustainable” has been used to describe the U.S.’s current fiscal path by Federal Reserve Chair Jerome Powell, officials at the International Monetary Fund, and even the U.S. Government Accountability Office. KBRA Financial Intelligence (KFI) has previously highlighted the desire of the White House and Treasury Department to achieve “lower rates” for the 10-year Treasury note, but progress on this front has essentially stalled since April.
A moderate decline in short-term rates and a temporary fall in long-term yields earlier this year allowed the Treasury to reduce the U.S.’s annualized expenses on interest payments in 1Q 2025, but the Congressional Budget Office’s (CBO) projection for the full fiscal year deficit still anticipates a third consecutive rise to $1.9 trillion. Further, the CBO’s first scoring of the reconciliation bill currently in Congress suggests that it could add $2.3 trillion to deficits over the next decade. Per an analysis by the Committee for a Responsible Federal Budget, a $113 billion decline in the fiscal 2025 deficit would be essentially erased by a $479 billion increase in 2026, followed by an even larger $597 billion surge in 2027.
Treasury Secretary Scott Bessent has signaled his support for extending the tax cuts enacted under the 2017 Tax Cuts and Jobs Act (TCJA), along with a range of new tax reductions. He emphasized that accelerating growth in the wake of these reductions will offset increases in the national debt. The Treasury Secretary has posited that the debt-to-GDP ratio is “the most important number” and maintains that faster economic growth will help stabilize it over time. Although the nonpartisan Tax Foundation estimates that the prospective tax reforms would boost long-term GDP by 1.1%, it would only cover 16% of revenue lost from reducing tax income. A recent KFI analysis found that U.S. banks benefited from an estimated $188 billion in collective income tax savings throughout a period of six years following the implementation of the TCJA.
Despite the recent downgrades to its previously pristine sovereign credit rating, the U.S. remains more highly rated than G7 peers such as France, the UK, Italy, and Japan. While it is possible that a higher term premium may eventually be priced into U.S. Treasury bonds—putting further upward pressure under rates—private sector lenders including the nation’s banks could see profits and equity valuations driven higher in the near term by some of the same factors contributing to diminished creditworthiness at the sovereign level.
Banks Could See Benefits and Risks From Yield Curve Shift
As long-term Treasury yields rise in response to macro trends, rates tied to bank lending will also rise. The recent increase in rates has concentrated at the long end of the yield curve, which has led to its steepening. Because the Fed is undertaking a gradual easing of monetary policy, currently holding short-term rates steady and projecting renewed rate cuts throughout 2025 and 2026, the rise in yields on long-term maturities has allowed the yield curve to escape inversion once again, with the spread between rates on 10-year and 3-month Treasurys (T10Y3M) rising to its highest level since February last week.
Bank profitability—as measured by net interest margin (NIM)—largely depends on their ability to fund long-term lending through deposits acquired at short-term rates. NIMs, loan volumes, and other key data for 10,000 individual U.S. banks and credit unions can be accessed via KFI’s web application, as well as the Data Wizard in KFI’s Excel add-in. To access our full library of tables and templates, request a demo today. If the yield curve continues its recent steepening trend, the uncertainty around government spending could actually bolster banks’ near-term financial results—provided borrowers remain creditworthy and economic growth does not weaken into recession.
Although rising yields can partly be attributed to concerns over the U.S. government’s fiscal health, higher long-term rates also tend to indicate that investors expect stronger economic growth ahead. U.S. GDP receded 0.3% quarter-over-quarter in 1Q 2025, but the decline was strongly influenced by a significant pre-tariff jump in imports that were likely a one-time occurrence. At the most recent FOMC press conference, Fed Chair Powell noted that the GDP figure excluding net exports, inventories, and government spending—known as private domestic final purchases (PDFP)—“grew at a solid 3% rate.” Total loan growth among U.S. commercial banks was also robust, expanding 3% throughout the quarter on a YoY basis. That marked the fastest annual increase in bank lending throughout the past seven quarters.
While equity markets can be more volatile indicators of economic sentiment, key indices such as the S&P 500 are mostly pointing toward improving optimism among investors, having rebounded toward all-time highs reached earlier this year. KFI data also shows that bank shares have not been left out of the 2Q rally. Notably, at one point in early April, the combined market capitalization of 337 publicly traded U.S. banks had fallen by as much as $472 billion year-to-date, but those losses have been completely reversed in subsequent weeks.
Rising rates can sometimes derail equity rallies, so it remains uncertain whether valuations will continue their comeback amid the gain in long-term yields. In addition, while banks can potentially earn more on loans, they will also face higher borrowing costs if they choose to issue debt. KFI previously highlighted a surge in U.S. banks’ bond issuance in 3Q 2024. That timing paid off for these institutions, as the average 10-year Treasury yield was equivalent to just 3.95% in that quarter, about 50 basis points below the same yield today.