Macroeconomic Outlook And Debt Sustainability
Short term (1-2 years) effects
The short-term effects of this bill on a macroeconomic perspective will yield positive result but much of the growth may be inflationary along with some productivity growth, and it will require the US government to run on a deficit of almost 3 trillion USD, which does raise questions about debt sustainability from the perspective of a longer term. Now in the short term with heavy investments and government spending, there will be a surge in growth of GDP. Along with that, to stimulate spending in the economy, the federal interest rates are likely to be low
Long term (5-10 years) effects
With the short-term effects in place .its important to discuss what the long-term effects of this bill are. Given the short-term growth is stimulated by debt, the inflation will climb to dangerously high levels, and to counter it the central bank will drive up the interest rates making borrowing difficult now. With less spending in the economy and even with it, if the government goes as the bill suggests, then there could go into a recession. With all the years
of running on deficits, the US national debt may climb to record levels. The question of whether the debt will be sustainable or not will depend on many future circumstances.
Possible effects on Key Macroeconomic Indicators
We see that in the recent quarters GDP growth rate had stagnated at around 3%, with the previous quarter showing negative growth, this bill plans to boost the growth rate of the GDP. In the short term the GDP Growth Rate of US GDP is expected to move to 3% as a baseline projection fueled by the demand stimulus that this bill generates. The Fed’s try to make sure that the inflation rate lingers around the 2% margin, post COVID they have successfully maintained so.
With the introduction of this bill, the Fed’s will try to decrease the interest rates to stimulate spending, the interest rates could tend to decrease to
around 2%-3%, and that could remain the same till the inflation crosses some certain boundary.
To counter it, the Fed’s will increase the interest rate back to the 4%-5% margin in order to drive down inflation. We notice that in the post COVID era the rate of unemployment is slowly climbing up, with layoffs due to AI and other factors playing a major role, now this bill is expected.
Understanding the effect of this bill with Crowding Out & Ricardian Equivalence
Using the crowding-out model to see what the outlook on private sector investments looks like, Mechanism of this model:
Debt Overhang Model to better explain the scenario
The mechanism of the debt overhang model:
Creating a model for all 3 scenarios along with the baseline projection of GDP growth rate and presenting it in the form of a line chart
To begin with modelling the debt-to-GDP ratio we will first consider 3 scenarios the baseline, the slowdown, and the rate shock. In the baseline scenario we assume that the GDP grows by 3% every year with stable borrowing and interest rates, the debt grows but is sustainable.
Now in the slowdown scenario, we assume the economic growth to slow down hence, we assume the GDP growth here to be 2% year on year while the spending and borrowing remains high, the debt is serviceable, but the fiscal flexibility decreases.
In case of a rate shock scenario where the interest rates suddenly rise sharply, with the debt to GDP reaching 165%, which is considered a dangerous territory, with the government spending more and more on interest payments, leaving less for productive spending. This could be considered a case of a classic debt overhang trap. A chart to present how the Debt-to-GDP ratio of all three scenarios would look over the next 10 years.
A second channel of impact from fiscal policy is the interaction between Treasury issuance and equity market volatility, as measured by the VIX index. Large debt-financed spending programs introduce multiple sources of uncertainty:
1. Higher Discount Rates
When the Treasury issues large amounts of debt, yields on government bonds tend to rise to attract buyers. Higher Treasury yields increase the cost of capital for businesses, particularly growth-oriented sectors like technology or consumer discretionary, whose valuations rely heavily on discounted
future cash flows. Historical evidence shows that periods of rising long-term yields often coincide with multiple equity market drawdowns, as higher discount rates reduce equity attractiveness relative to fixed income.
2. Market Volatility Spillovers
During weeks of heavy Treasury issuance, investors often rebalance portfolios toward safer assets, such as Treasuries or cash equivalents, creating temporary equity outflows. Research by the Federal Reserve and academic studies (e.g., Greenwood & Vayanos, 2010) shows that large net issuance correlates with spikes in implied equity volatility. These spillovers are amplified when issuance coincides with other market stressors, such as
geopolitical uncertainty or economic data surprises.
3. Liquidity Stress
In stressed markets, a “dash for cash” can occur, where investors sell equities and corporate bonds to raise liquidity, often to purchase Treasury securities.
If Treasury auctions fail to clear smoothly or yields rise sharply during the process, this feedback loop can exacerbate volatility, creating short-term dislocations in equity and credit markets. Historical examples include the 2008–2009 financial crisis and the March 2020 COVID-19 market selloff, when Treasury demand surged while equities plummeted.
4. Investor Expectations and Forward Guidance
Equity markets respond not only to actual issuance but also to the Treasury’s communication strategy. Clear forward guidance on upcoming auctions, supply size, and interest rate policy can reduce uncertainty, mitigating spikes in volatility. Conversely, unexpected or opaque debt issuance can fuel speculative positioning, increasing short-term VIX readings.
Credit spreads widening (corporate & sovereign)
Credit spreads are the premium investors demand over U.S. Treasuries that are highly sensitive to fiscal shocks. Following Big And Beautiful Bill, spreads are expected to widen across corporate and sovereign 
For sovereigns, especially in emerging markets (EMs), spreads tend to widen when U.S. yields rise, as their debt is benchmarked against Treasuries. This not only raises borrowing costs but can also trigger capital outflows, currency pressure, and heightened refinancing risks.
Credit spreads are often viewed as a real-time barometer of market sentiment. When investors feel confident, spreads tighten as demand for corporate and sovereign bonds rises. But in periods of fiscal stress, like after Big And Beautiful Bill, spreads widen sharply because investors require extra
compensation for perceived risk. Wider spreads mean companies and governments must pay more to borrow, even if their fundamentals have not changed. This can create a feedback loop: higher borrowing costs weaken balance sheets, which in turn justifies even wider spreads.
Foreign capital flow risks (capital flight, EM, vulnerability)
Foreign capital flows are one of the most important channels through which U.S. fiscal policy shocks transmit to the global economy. The U.S. Treasury market is the world’s largest safe-asset pool, and foreign investors particularly central banks, sovereign wealth funds, and global asset managers hold a significant share of outstanding U.S. debt.
Episodes such as the 2013 “Taper Tantrum” highlight the scale of vulnerability: abrupt changes in U.S. policy expectations triggered billions of dollars in EM outflows, sharp currency falls, and higher bond yields. A similar dynamic could occur if markets perceive BABB as undermining U.S. fiscal
credibility. Ultimately, capital flow volatility not only raises financing costs but can also reduce policy space for EM governments.
Systemic Risks
1. U.S. sovereign debt downgrade
Current status: Debt/GDP ~124% (IMF/Trading Economics 2024). Fitch downgraded U.S. debt to AA+ in Aug 2023; S&P already downgraded in 2011.
Risk: Another downgrade could push Treasury term premia up 20–40 bps and widen CDS spreads, raising global borrowing costs.
Trigger: Persistent primary deficits + lack of credible fiscal anchors.
Client safeguard: Shorten duration in U.S. Treasuries; increase allocation to TIPS and high-grade foreign sovereigns.
2. USD weakening
Current status: Dollar = ~59% of global FX reserves (IMF COFER 2024), down from 71% in 1999.
Risk: Fiscal credibility erosion could accelerate diversification to EUR, JPY, CNY, and gold. A 5–10% USD depreciation would raise import inflation and undermine Treasury safe-haven status.
Trigger: Market perception of fiscal dominance; loss of reserve confidence.
Client safeguard: Hedge FX exposure with forwards/options; tilt to gold, commodities, and non USD assets.
3. Global spillovers
Current status: U.S. Treasuries = ~$27tn market; foreign official sector holds ~30% (2024 Treasury data).
Risk: Rapid U.S. yield spike transmits globally: EM sovereign spreads can widen 100–300 bps (seen in 1998 Russia, 2013 Taper Tantrum). Repo collateral strain can spill to global bank
Scenario Analysis
Asset Allocation Playbook
1. Gold: Rationale: Hedge against inflation, a haven during USD weakness.
2. TIPS (Treasury Inflation-Protected Securities) Rationale: Protects bond portfolios if CPI inflation exceeds the Fed’s 2% target.
3. Commodities (Energy, Agriculture, Metals) Rationale: Hedge against supply disruptions and policy-driven demand.
4. Global Equities (ex-US developed + EMs) Rationale: Diversify away from U.S. policy uncertainty, capture EM growth.
Hedging Strategies
Currency Hedging – Protecting Against USD Depreciation
Context: Large U.S. deficits and spending raise the risk of a weaker dollar, which can erode returns on dollar assets. Hedging is essential to protect portfolios and maintain stability. HNIs (High Net-Worth Individuals):
Currency-Hedged ETFs (Exchange-Traded Funds): Provide international equity exposure while neutralizing USD currency fluctuations. This allows HNIs to diversify into global assets without being directly impacted by exchange rate swings.
Euro/CHF-Denominated Assets: Allocating capital into Euro- or Swiss Franc-based assets provides natural currency diversification. Both currencies are traditionally more stable and act as a hedge against USD weakness.
Institutions: FX Forwards/Swaps: Forward contracts and cross-currency swaps enable institutions to lock in future exchange rates or exchange cash flows in different currencies. These tools provide flexibility in actively managing large-scale USD exposures.
EM Local Currency Debt: Allocating to emerging market government bonds denominated in local currencies provides both yield enhancement and currency diversification. As the USD weakens, local currencies may strengthen, amplifying returns. Interest Rate Hedging – Managing Treasury Yield Risk
Interest Rate Hedging – Managing Treasury Yield Risk
HNIs (High Net-Worth Individuals):
Short-Duration Bond Funds: Bonds with shorter maturities are less sensitive to interest rate changes, reducing volatility in fixed income allocations.
Floating-Rate Notes: Coupon payments on these securities reset periodically with prevailing interest rates, ensuring protection in a rising-rate environment.
2–5 Year Bond Ladders: Structuring bond investments with staggered maturities between 2–5 years lowers reinvestment risk and ensures liquidity while capturing higher yields over time.
Institutions:
Interest Rate Swaps/Futures: These derivatives allow institutions to manage duration exposure actively, either by swapping fixed-rate obligations for floating rates or hedging bond price declines through futures contracts. Customized Bond Ladders (1–10 years): Extended ladders provide institutions with flexibility, balancing long-term yield opportunities with liquidity management.
TIPS (Treasury Inflation-Protected Securities): Inflation-linked securities safeguard real returns, ensuring purchasing power is protected when yields are driven higher by inflationary pressures
Hedging Decision Tree & Risk Return Scatter Plot
Global capital flows are undergoing significant shifts driven by US fiscal stimulus and
monetary policy adjustments, impacting regional asset valuations and funding conditions.
The US market remains resilient, buoyed by fiscal support, attracting strong capital inflows,
particularly into growth sectors such as technology and infrastructure.
Emerging markets, especially in Asia, continue to receive robust capital inflows, underpinned
by improving investor sentiment and growth prospects.
European markets encounter moderate growth challenges and tighter funding conditions,
reflecting a slower recovery and structural headwinds.
Inflation pressures are easing worldwide, although central banks maintain cautious policy
approaches, influencing borrowing costs and market volatility.
To navigate these uncertainties, investors should focus on effective risk management, including the use of inflation hedges, duration control, and currency strategies, is essential to balance growth opportunities with potential market risks.
Bibliography
https://data.imf.org/en
https://home.treasury.gov/resource-center/data-chart-center/interest-rates
https://www.cboe.com/vix/
https://fiscaldata.treasury.gov/
https://tradingeconomics.com/united-states/indicators
https://moneywithkatie.com/the_mwk_show/ray-dalio/
https://www.congress.gov/bill/119th-congress/house-bill/1
https://economic-research.bnpparibas.com/html/en-US/updated-scenario
forecasts-Economic-Research-1-September-2025-9/1/2025,51187
https://www.federalreserve.gov/publications/2025-stress-test-scenarios.htm
https://www.imf.org/en/Home
https://tradingeconomics.com/
https://www.imf.org/en/Countries/GRC