$40 Trillion in US Federal Debt Has Yet to Put the Brakes on the Private Sector, but High Bond Yields Are Testing Equities' Relative Appeal

Overview

The report examines whether global fiscal expansion and rising interest rates will suppress corporate and household activity through heavier debt burdens, or even disrupt the calm in financial markets. It concludes that public-sector leveraging has largely corresponded with improved private-sector balance sheets, leaving a high threshold for the traditional borrowing-demand “brake” to engage. The greater concern is that, as long-term bond yields rise, asset allocators may shift from equities to bonds, while equities' ability to remain competitive depends on earnings growth.

Core views

The report begins by reviewing the debt debate following the global financial crisis. At the time, markets broadly feared that rising government debt would produce weak growth and prolonged fiscal austerity, but these pessimistic forecasts did not materialize: global growth remained resilient, investment and capital deepening continued, and developed-market equities and currencies instead emerged as beneficiaries. Meanwhile, the United States accumulated approximately $20 trillion in federal debt over its first roughly 240 years and borrowed another approximately $20 trillion over the past decade. Measuring debt as a share of GDP does not change the direction: government leverage has generally risen across major economies, fiscal deficits are not expected to narrow except in the United Kingdom, and the charts even point toward further deficit expansion. The report argues that assessing whether government debt has become a “brake” on corporate and household activity requires looking beyond public debt alone. In many countries, deterioration in public-sector debt relative to GDP has coincided with improvements in corporate and household balance sheets; once the trade balance is included, this is also an accounting relationship arising from sectoral financial balances. The United States, France, Japan, Sweden, Switzerland, Italy, and the United Kingdom have all reduced tax rates at some point over the past decade, reflecting deliberate policy choices to transfer resources from the public sector to the private sector. It is therefore unsurprising that public balance sheets have deteriorated while private-sector balance sheets have improved. On the corporate side, surging technology investment and a recovery in M&A activity are driving an issuance boom, and Morgan Stanley's credit strategy team continues to expect record issuance in 2026. The report judges that the market can still absorb these bonds, with credit spreads widening only modestly: the US corporate debt-to-GDP ratio has remained broadly unchanged over the past decade and is below its COVID-19-era level; hyperscale cloud providers have low leverage, while AI investment offers high returns on capital, providing some support for companies' ability to accept higher financing costs. The report therefore does not expect current yields to end this historic financing wave. The household sector carries more debt in aggregate but is in stronger overall condition. US household debt is approximately 67% of GDP, below roughly 70% in 2000 and 6 percentage points below the 74% level in 2019. Moreover, a substantial share of this debt consists of mortgages locked in at historically low interest rates, while household assets have also improved materially. Aggregate data do conceal divergence between high- and low-income households, but overall consumption is more strongly supported by aggregate balance sheets, helping explain why consumption has remained resilient despite high interest rates and rising energy prices. Interest-rate-sensitive industries such as housing are already depressed, so the report believes households will not rapidly respond to this round of rising rates with another major contraction. This pattern of public-sector leveraging and private-sector deleveraging is not unique to the United States. As European government debt-to-GDP ratios have risen, corporations and households have deleveraged by a greater amount; in Japan, public borrowing has increased while private-sector leverage has remained stable. Government debt therefore currently resembles a transfer of balance sheets between sectors more than a mechanical shock that immediately crushes private demand. Nevertheless, the report continues to ask how long this condition can persist and whether the true market “break” could come from somewhere other than borrowers. The recent rise in yields has been accompanied by pressure on US long-term rates and intervention in Japan's foreign exchange market, but stress indicators do not yet suggest disorder: US 10-year inflation expectations are approximately 2.3%, the yield curve's steepness is around average, and interest-rate volatility is low, none of which supports a conclusion of severe stress or a crisis of policy credibility. The report expects the effects of intervention to be short-lived and the US 7-year-to-30-year curve to resume steepening; however, more aggressive US Treasury actions could pressure the dollar. The report locates the stronger potential turning-point signal among asset allocators rather than borrowers. The current US 30-year Treasury yield is approximately 300 basis points above expected inflation, while long-term US investment-grade bonds yield 6.2%. The threshold at which interest rates truly “have an impact” may therefore not be when companies stop borrowing or households stop consuming, but when investors conclude that these fixed-income instruments offer a better risk-return profile than equities and begin reallocating capital. Such a shift has not yet been observed: neither fund flows nor equity-bond correlations show a systematic movement of capital from equities to bonds, and equity and bond prices continue to move in the same direction. The S&P 500 has risen 13% year to date while the US 10-year rate has increased by 50 basis points, yet the equity risk premium, measured by Morgan Stanley strategists as the earnings yield minus the bond yield, has remained unchanged. This is because earnings growth has been strong enough to keep equities competitive in the face of higher bond yields, similar to conditions in the late 1990s. However, this also increases the importance of sustained earnings growth, and any future slowdown could weaken equities' relative appeal. From a relative-value perspective, the report favors markets with stronger fiscal positions: it is bullish on UK inflation-linked bonds because the United Kingdom is one of the few cases where the deficit is expected to narrow; it also favors the Australian dollar, based on a higher interest-rate differential and Australia's government debt-to-GDP ratio of only 49%. These views do not alter the report's expectation that global government debt will continue expanding, but instead emphasize that fiscal divergence can create cross-market opportunities. Regarding this week's US data, the report expects year-over-year home-price growth to have recovered from a March low of 0.8% to 1.1% in May, supported by slowing inventory growth, with year-over-year home-price appreciation expected to reach 2% by year-end. July new-home sales are forecast at 625,000 units, down 0.5% month over month, versus a previous reading of 628,000. The sharp decline in July housing starts is viewed as noise because permits did not weaken in tandem, although mortgage applications and homebuilder confidence have deteriorated. Consumer confidence remains low, with the net share reporting plentiful jobs falling from 11.0% a year earlier to 3.1% in July, while the preliminary August University of Michigan reading has again approached May's record low. On inflation and household income and spending, the report expects US core PCE to rise 0.23% month over month in July and headline PCE to rise 0.14%. The three- and six-month annualized rates for core PCE are expected to be 2.79% and 3.30%, respectively, below June's 2.89% and 3.76%, while the year-over-year rate is expected to edge down from 3.29% to 3.27%. Market-based core PCE, which excludes imputed items such as portfolio management, is expected to rise just 0.13% month over month, while trimmed-mean PCE is forecast to rise 0.18%. Because the skewness of the distribution of price changes shifted from positive in late 2025 to negative in June and is expected to remain negative in July, the report cites related research suggesting that the trimmed mean provides a better reflection of the underlying inflation trend under these conditions. The report expects real US consumption to be unchanged month over month in July, with goods consumption down 0.5% and services consumption up 0.2%. Weakness in goods primarily reflects payback after strong durable-goods consumption in the second quarter, while online sales may have pulled some demand forward into June. Services consumption is expected to temporarily retain the boost from the June World Cup, with that effect projected to reverse in August. Nominal personal income is expected to rise 0.2%, labor compensation by approximately 0.2% to 0.3%, real disposable income to remain unchanged, and the saving rate to stay at 2.7%. The tracking estimate for second-quarter US real GDP growth is 1.4% quarter-over-quarter annualized, close to the 1.5% initial reading. Consumption growth is projected at approximately 3.1% to 3.2%, but its composition is expected to be revised upward for services and downward for goods. Other US forecasts include: the July goods trade deficit is expected to widen from $101.4 billion to $103.0 billion; initial jobless claims are expected to remain at 206,000, while continuing-claims data suggest that the pace of reemployment has slowed from the beginning of the year; the nonfarm payroll benchmark revision is expected to be small, unlike the substantial downward revisions of the past two years, although unreleased first-quarter Quarterly Census of Employment and Wages data could still affect the result. Germany's August ifo Business Climate Index is expected to edge down from 86.6 to 86.5. In Asia-Pacific, Australia's July CPI is expected to rise 0.9% month over month and 3.3% year over year, with the monthly rebound driven mainly by the expiration of fuel subsidies and a recovery in travel prices. The Bank of Thailand is expected to vote unanimously to keep rates unchanged and maintain an accommodative stance to support the recovery. The Bank of Korea is expected to deliver the second rate hike of this cycle on August 27, raising the rate to 3.0% and using its dot plot to guide the terminal rate upward toward 3.5%. The central bank of the Philippines is expected to raise rates by 25 basis points to return inflation to target and stabilize expectations. Japan's August Tokyo headline CPI, core CPI excluding fresh food, and core-core CPI excluding fresh food and energy are expected to rise 1.8%, 1.7%, and 1.9% year over year, respectively. The July unemployment rate is expected to remain at 2.5%, while the active job-openings-to-applicants ratio is forecast to edge up to 1.19.

Analysis framework

The report first establishes a baseline using the historical experience of post-global-financial-crisis debt concerns that failed to materialize, then uses the balance-sheet relationships among the government, corporate, household, and external sectors to explain why public-sector leveraging can coexist with private-sector deleveraging. It subsequently examines corporate financing capacity, household debt-servicing capacity, and cross-country differences, while observing whether inflation expectations, the yield curve, and interest-rate volatility indicate market disorder. Finally, it uses fund flows, equity-bond correlations, the equity risk premium, and earnings growth to assess the potential turning point in asset allocation, translating its cross-asset views into preferences for UK inflation-linked bonds and the Australian dollar, as well as forecasts for this week's macroeconomic data.

Methodology notes

• Macroeconomic framework

  Sectoral Financial Balances and Corresponding Balance-Sheet Relationships

  The report analyzes the government, corporate, household, and trade sectors within a unified accounting framework: widening public-sector deficits often correspond to improved private-sector financial conditions, so an increase in government debt alone does not necessarily imply a contraction in private demand.

• Corporate Fundamentals and Financial FrameworkOperating/Financial Leverage Analysis

  Analysis of Corporate and Household Debt-to-GDP Ratios and Capacity to Bear Financing Costs

  Rather than examining absolute debt levels alone, the report uses historical changes in debt-to-GDP ratios, interest rates on outstanding debt, improvements on the asset side, and returns on capital to assess whether corporations and households can withstand higher yields.

• Fixed-Income and Credit AnalysisYield curve analysis

  Long-End Yields, Curve Steepness, and Interest-Rate Volatility

  The report combines 10-year inflation expectations, yield-curve steepness, and interest-rate volatility to assess whether the market is exhibiting pressure related to fiscal credibility, and on that basis forecasts renewed steepening of the US 7-year-to-30-year curve.

• Quantitative/Factor/Portfolio Theory

  Equity Risk Premium and Equity-Bond Relative Value

  The report measures the compensation offered by equities relative to bonds as the equity earnings yield minus the bond yield, and uses earnings growth to explain why equities remain competitive despite rising bond yields.

• Event-Driven Strategy and Behavioral FinanceFund Flow/Positioning Analysis

  Observation of Fund Flows and Equity-Bond Correlations

  The report uses fund flows and correlations between equity and bond prices to test whether investors have already shifted from equities to bonds; neither indicator currently shows systematic reallocation.

• Macroeconomic framework

  Multiple PCE Measures and Skewness of the Price-Change Distribution

  The report compares core, market-based core, and trimmed-mean PCE, using the skewness of the distribution of price changes to determine which measure better reflects the current underlying inflation trend.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• US Corporate Bonds

  Technology investment and the recovery in M&A are driving record issuance, and the report expects the market to continue absorbing the additional supply.

  Strengths

  The US corporate debt-to-GDP ratio has remained broadly unchanged over the past decade and is below its COVID-19-era level, hyperscale cloud providers have low leverage, and AI returns on capital are high.

  Weaknesses

  Large-scale issuance may cause modest credit-spread widening.

  Comparison

  Relative to the continuously leveraging public sector, the leverage trend in the US corporate sector is more stable.

  Risks

  If financing costs rise further or returns on AI investment prove insufficient, current financing capacity may be tested.

• US 30-Year Treasuries

  The yield is approximately 300 basis points above expected inflation, making it an important benchmark as investors assess equity-bond reallocation.

  Strengths

  Offers relatively high expected real-yield compensation.

  Weaknesses

  Current fund flows and correlations do not yet indicate that investors have systematically shifted into long-term Treasuries.

  Comparison

  Relative to equities, its attractiveness will depend on the gap between bond yields and equity earnings yields.

  Risks

  The impact of intervention in long-term rates may be short-lived, and the 7-year-to-30-year curve could still resume steepening.

• Long-Term US Investment-Grade Bonds

  A yield of 6.2% increases their allocation appeal relative to other risk assets.

  Strengths

  Absolute yields are high and supported by broadly sound corporate balance sheets.

  Weaknesses

  The report still expects additional supply to cause modest spread widening.

  Comparison

  They may gradually become a more competitive risk-return choice than equities.

  Risks

  If credit spreads widen more than the report expects, price performance may come under pressure.

• US Equities

  Strong earnings growth has offset the valuation competition from rising bond yields, allowing equities to remain relatively attractive for now.

  Strengths

  The S&P 500 has risen 13% year to date, while the equity risk premium remained unchanged despite a 50-basis-point increase in the US 10-year rate.

  Weaknesses

  Relative attractiveness is increasingly dependent on sustained earnings growth.

  Comparison

  Equities have not yet lost out to high-yielding long-term bonds, but the risk-return gap between them is narrowing.

  Risks

  A future slowdown in earnings growth could trigger a shift of capital from equities to bonds.

• UK Inflation-Linked Bonds

  The report explicitly expresses a favorable view, as the United Kingdom is one of the few cases where the fiscal deficit is expected to narrow.

  Strengths

  The direction of its fiscal deficit is better than that of other major economies.

  Comparison

  Deficits in most major economies are not expected to narrow, making the United Kingdom an exception.

• Australian Dollar

  The report explicitly expresses a favorable view on the Australian dollar.

  Strengths

  The interest-rate differential is high, while Australian government debt is only 49% of GDP.

  Comparison

  Fiscal leverage is lower than in many of the developed economies emphasized in the report.

• US Dollar

  The report believes more aggressive actions by the US Treasury could pressure the dollar.

  Weaknesses

  Could be weighed down by more aggressive intervention or actions by the US Treasury.

  Risks

  There is uncertainty regarding the impact and duration of the relevant policies.

Key data

• Accumulation of US Federal DebtApproximately $20 trillion over the first roughly 240 years, followed by another approximately $20 trillion over the past decadeIllustrates the rapid expansion of debt over the past decade
• US Household Debt-to-GDP RatioApproximately 67%Below roughly 70% in 2000 and 6 percentage points better than the 74% level in 2019
• US 10-Year Inflation ExpectationsApproximately 2.3%The report believes this does not yet indicate clear pressure on policy credibility
• Real-Yield Compensation on US 30-Year TreasuriesApproximately 300 basis points above expected inflationIncreases the attractiveness of long-term Treasuries relative to other assets
• Long-Term US Investment-Grade Bond Yield6.2%Represents a potential threshold for equity-bond reallocation
• S&P 500 Year-to-Date Performance+13%The US 10-year rate rose by 50 basis points over the same period, but the equity risk premium remained unchanged
• Australian Government Debt-to-GDP Ratio49%Together with the high interest-rate differential, this supports the report's bullish view on the Australian dollar
• US Home-Price Growth1.1% year over year in May, versus a March low of 0.8%, with 2% year-over-year growth expected by year-endSlowing inventory growth is expected to continue supporting home prices
• US July New-Home Sales Forecast625,000 units, -0.5% month over monthThe previous reading was 628,000 units
• US Net Share Reporting Plentiful Jobs3.1% in JulyDown from 11.0% a year earlier, indicating weaker consumer assessments of the labor market
• US July Core PCE Forecast+0.23% month over month, 3.27% year over yearThe previous year-over-year reading was 3.29%
• US Core PCE Short-Term Annualized Growth2.79% over three months and 3.30% over six monthsBelow June's 2.89% and 3.76%, respectively
• Forecasts for Other US July PCE MeasuresMarket-based core PCE +0.13% month over month, trimmed-mean PCE +0.18% month over monthUsed to help identify the underlying inflation trend
• US July Real Consumption ForecastUnchanged month over monthGoods -0.5%, services +0.2%
• US July Income and Savings ForecastNominal personal income +0.2%, labor compensation +0.2% to +0.3%, saving rate 2.7%Real disposable income is expected to be unchanged month over month
• US Second-Quarter Real GDP Tracking Estimate1.4% quarter-over-quarter annualizedThe initial reading was 1.5%, with consumption expected to grow 3.1% to 3.2%
• US July Goods Trade Deficit Forecast$103.0 billionThe previous reading was $101.4 billion
• US Initial Jobless Claims Forecast206,000Expected to remain unchanged from the previous period
• Germany August ifo Business Climate Index Forecast86.586.6 in July
• Australia July CPI Forecast+0.9% month over month, +3.3% year over yearThe expiration of fuel subsidies and a recovery in travel prices drive the monthly rebound
• South Korea Policy Rate ForecastRaised to 3.0%Expected to be the second rate hike of this cycle, with terminal-rate guidance potentially rising to 3.5%
• Forecast Philippine Policy Rate Action25-basis-point rate hikeIntended to return inflation to target and stabilize inflation expectations
• Japan August Tokyo CPI ForecastHeadline 1.8%, core 1.7%, core-core 1.9%All are year-over-year growth rates
• Japan July Labor Market ForecastUnemployment rate 2.5%, active job-openings-to-applicants ratio 1.19The unemployment rate is expected to remain unchanged, while the job-openings-to-applicants ratio edges higher

Impact & implications

The report believes that public-debt expansion has not yet rapidly reduced financing, investment, or consumption through corporate and household balance sheets, so further yield increases may not immediately end corporate bond issuance or household spending. The key market impact is that the risk-return profile of fixed-income assets is improving: if earnings growth slows, equities' advantage over bonds may weaken and trigger capital reallocation. Cross-market fiscal differences are therefore also becoming more important: a narrowing UK deficit supports the view on inflation-linked bonds, while Australia's lower government leverage and high interest-rate differential support the Australian dollar.

Risks

• Government debt-to-GDP ratios across major global economies continue to rise, while fiscal deficits are not expected to narrow except in the United Kingdom, potentially disrupting the current market calm eventually.
• Equities' ability to remain competitive depends heavily on earnings growth; a future slowdown in earnings growth could weaken the equity risk premium and trigger equity-bond reallocation.
• Rising yields on US 30-year Treasuries and long-term investment-grade bonds may lead investors to conclude that bonds offer a better risk-return profile than equities.
• The strength of aggregate US household balance sheets conceals significant divergence between high- and low-income households.
• More aggressive actions by the US Treasury could weaken the dollar.
• Increased long-term bond issuance could widen credit spreads, even though the report's base case calls for only modest widening.

What to watch

• Monitor whether fund flows and equity-bond correlations begin to indicate that investors are shifting from equities to bonds.
• Track whether corporate earnings growth can continue offsetting rising bond yields and whether earnings growth slows in the future.
• Watch whether US 10-year inflation expectations, yield-curve steepness, and interest-rate volatility begin to indicate pressure on fiscal or policy credibility.
• Monitor whether the US 7-year-to-30-year curve resumes steepening as the report expects and assess the impact of US Treasury actions on the dollar.
• Watch whether the market can absorb record corporate bond issuance with only modest credit-spread widening.
• Track US home prices, new-home sales, consumer confidence, PCE inflation, personal consumption and income, GDP, the trade deficit, and jobless claims.
• Watch Australian CPI and the policy decisions of the central banks of Thailand, South Korea, and the Philippines.
• Track Tokyo CPI, the unemployment rate, and the active job-openings-to-applicants ratio in Japan.