Mind the $2 Trillion Gap

With the recent movements in both the stock and bond markets, there was some noteworthy news that got kind of lost. Indeed, the U.S. government posted a $1.99 trillion budget deficit for fiscal year (FY) 2026. While technically it is not a record amount of red-ink, it represented the largest non-COVID-related shortfall ever recorded in modern history.

The key question to ask is how much it actually matters for the bond market in the grand of schemes. That is certainly a fair query to ponder. We have opined on many occasions that budget deficits are not typically the primary driver of where interest rates are headed. To be sure, macro forces, such as the economy, inflation and any monetary policy decisions are the primary drivers for rates. That being said, budget deficits and attendant supply considerations can have secondary effects and can either add to or delete from an existing trend.

Against this backdrop, let’s dive a little deeper into the nation’s balance sheet. Here are the most pertinent facts:

• The FY deficit rose by $217 billion, or +12.2% to $1.99 trillion
• Total revenues rose +3.2%, led by an increase of almost $190 billion in individual income tax receipts
• For those keeping track, the tariff-related customs duties category actually fell by roughly $22 billion
• Total outlays increased +5.5%, more than eclipsing any gains on the revenue side of the ledger

On the spending side, two of the more non-interest related culprits behind the higher total were Department of Defense and Department of Health and Human Services (HHS). Increased outlays for Defense should not come as a surprise given the war in the Middle East. With respect to HHS, the overall year-over-year increase was centered in Medicare and Medicaid.

Obviously, one of the more talked about areas within total outlays is interest on the public debt. While some of the focus is on the ‘net’ interest figure, we believe the ‘gross’ amount is what we should be looking at because that is the actual amount of interest the Treasury is paying on the public debt. With that in mind the total figure for FY 2026 came in at $1.4 trillion, up nearly 12% from the prior fiscal year. The aspect of interest outlays that receives the lion’s share of attention is what percentage does that make up for total outlays, and that figure is 18.4%, a full percentage point above the FY 2025 number.

So, that brings us to the question of where the deficit will be headed and the potential implications for the Treasury (UST) market. The beginning point to keep into consideration is that the baseline red ink total for the U.S. going forward is $2 trillion. Based on estimates from the Congressional Budget Office (CBO), this shortfall will be going in an ascending trajectory, and certainly not the other way around.

Against this backdrop, it has now become a matter of when, not if, the nation’s debt managers have to increase coupon auction sizes. As we mentioned earlier, deficits and supply may not be a primary driver for future interest rate trends, but the budget-related backdrop will definitely not be a ‘rate-friendly’ one looking ahead.