Charts Showing How the Markets Have Responded to Deficits

Concerns about government deficits are once again making waves on Wall Street. Many investors attribute the recent rise in Treasury yields, which influence borrowing costs across the economy, to expectations of larger budget deficits in a potential second Trump administration. The projected budget shortfall of $1.9 trillion for this year—exceeding 6% of the nation’s economic output—has only occurred in extraordinary circumstances, such as World War II, the 2008-09 financial crisis, and the Covid-19 pandemic. Despite this, stock markets continue to climb to new heights.

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With President-elect Trump’s proposed tax cuts and rising costs for Social Security and Medicare expected to maintain historically high deficits, the debate over fiscal policy and its impact on investments has reignited. Examining past administrations provides insight into how fiscal policy has historically influenced markets.

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Ronald Reagan, 1981-89

President Reagan’s sweeping 1981 tax cuts significantly increased the federal deficit, peaking at 5.7% of GDP in 1983. Concerns among investors led economist Edward Yardeni to coin the term "bond vigilantes," referring to investors who demand higher rates to compensate for risks associated with budget imbalances and inflation.

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At the time, the Federal Reserve’s aggressive inflation-fighting policies pushed the 10-year Treasury yield above 15%. This combination of high yields and expansive fiscal policies attracted foreign capital, strengthening the U.S. dollar. The dollar’s rise prompted a coordinated effort by developed nations in 1985 to weaken it during the Plaza Accord.

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George H.W. Bush, 1989-93

Deficit reduction became a central focus under President George H.W. Bush, who broke his “No new taxes” pledge to tackle the national deficit. This bipartisan effort included both spending cuts and tax increases.

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During Bush’s tenure, the deficit peaked at 4.4% of GDP following the 1991 recession but fell to 3.7% by 1993. The 10-year Treasury yield also dropped, declining by nearly 2.5 percentage points to around 6.4% by the end of his presidency.

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Bill Clinton, 1993-2001

Upon entering office in 1993, President Clinton faced the challenge of balancing campaign promises for deficit reduction and middle-class tax relief. Influenced by advisors like Robert Rubin, Clinton prioritized deficit reduction to lower long-term Treasury yields.

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Although the 10-year yield surged above 8% in 1994 amid the Federal Reserve's rate hikes, it eventually retreated as Clinton’s policies turned deficits into surpluses. According to David Wessel, director at the Brookings Institution, the era demonstrated how reducing deficits could lead to lower interest rates and increased investment, aligning with economic theory.

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George W. Bush, 2001-09

Under President George W. Bush, deficits grew to record levels following tax cuts in 2001 and 2003 and significant military spending after the September 11 attacks. Stocks largely recovered from the dot-com bust, with short-term rates climbing above 5%.

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However, the 2008-09 financial crisis, triggered by the housing market collapse, drastically altered the economic landscape. Stock markets plummeted, and the Federal Reserve slashed short-term rates to zero to stabilize the economy.

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Barack Obama, 2009-17

President Obama’s early stimulus measures to combat the financial crisis pushed deficits higher. Over time, however, tighter fiscal policies contributed to a sluggish economic recovery. The Fed maintained near-zero interest rates and purchased bonds to support financial stability, fostering a tech-driven stock market rally.

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Debt ceiling disputes in 2011 led to fears of a missed Treasury payment and a U.S. credit downgrade, causing market volatility. Despite these challenges, Treasurys remained a safe haven for investors during the crisis.

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Donald Trump, 2017-21

The Trump administration’s tax cuts reignited deficit growth as a share of GDP, fueling a "reflation trade" characterized by rising bond yields and surging stocks, especially in sectors like banking, industrials, and small-cap companies.

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The Covid-19 pandemic in Trump’s final year further widened deficits, with bipartisan spending packages driving economic recovery. Treasury yields hit historic lows, and stocks rebounded rapidly as the Federal Reserve slashed rates to near zero.

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Joseph Biden, 2021-Present

President Biden’s administration sustained high levels of government spending. To combat inflation, the Federal Reserve began aggressive rate hikes, raising borrowing costs and increasing government interest payments. Tax revenue declined, and the government sold more bonds to bridge the funding gap, leading to a bond market rout and pushing the 10-year Treasury yield to 5%.

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Shifting borrowing toward shorter maturities helped stabilize markets. Despite fears, Wall Street has absorbed the government’s borrowing surge without major disruptions. Strong economic performance and expectations of higher deficits in a second Trump administration have driven bond yields higher recently.

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While rising yields may increase corporate profits temporarily, some investors caution that sustained high rates could dampen investment spending. According to Sonu Varghese of Carson Group, deficit spending typically boosts corporate earnings but can strain markets if borrowing costs remain elevated for too long.

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Conclusion

As fiscal policy debates resurface, historical patterns suggest that the relationship between deficits, interest rates, and market performance is complex. While deficit-driven spending has sometimes supported corporate profits and stock market gains, persistent imbalances could pose long-term risks, especially if they trigger sustained inflation or higher borrowing costs.

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