By the time the U.S. budget deficit reached $1.4 trillion in fiscal (October) 2009, alarm bells were sounding everywhere. Unless the government could get its fiscal house in order, the future promised years of misery as the U.S. kowtowed to its bondholders in China, Japan and elsewhere.

But this crisis simply never came to pass. Thanks to a range of factors for which both political parties can take some credit, the budget gap has already narrowed sharply. According to the Congressional Budget Office (CBO), the budget deficit will fall even further in fiscal 2014 and 2015.

A Fast-Shrinking Deficit

In another bit of good news, the recent era of very low interest rates has enabled Uncle Sam to keep interest payments in check. Five years ago, the government was paying a roughly 4% interest rate on its debt. That figure has fallen by more than 150 basis points since then.

*CBO estimate

#-ad_banner-#The net result of the drop in interest rates: Uncle Sam has saved nearly $200 billion in annual interest expense (in light of the growing total debt since then and assuming interest rates had stayed constant at 2008 levels).

The tougher road ahead
Yet just as many investors have begun to stop thinking about our massive debt (which totals $12 trillion when Social Security liabilities are excluded), a pair of factors may conspire to make this a prominent concern again in 2014, and a real crisis within a few years.

And the blame goes to the resurgent U.S. economy.

As I noted in another column this week, the U.S. economy enters the new year on firmer footing, with some economists anticipating GDP growth in excess of 3% this year. And that should start to push interest rates on longer-term bonds higher. Interest rates on shorter-term debt, known as short rates, are likely to stay quite low for at least the next 12 to 18 months.

But that creates a real conundrum. If the government tries to keep its borrowing costs as low as possible by issuing short-term bonds and Treasury bills, then it will need to roll over that debt in a few years anyway, at which time even short rates may be notably higher.

If the government aims to avoid that scenario and instead issuer longer-term bonds, then it will already see higher interest rates as 2014 plays out. It’s safe to say that the era of federal borrowing costs below 2.5% has come to an end.

Every 1-percentage-point increase in the government’s borrowing costs raises interest expenses by $120 billion. And that assumes that the size of our debt will remain constant. But that won’t be the case: Even though the deficit is shrinking, total debt is growing, and the CBO ominously warns that the deficit will start to grow at an accelerating pace, thanks to increases in mandatory entitlement spending.

The CBO’s conclusion: “The government’s net interest costs are projected to more than double relative to the size of the economy over the next 10 years — from 1.3% of GDP in 2013 to more than 3% by 2023.”

To keep that from happening, the government would need to find an additional $2 trillion in cumulative savings over the next decade, according to the CBO, which “would require significant increases in taxes, significant cuts in in federal benefits and services, or both.” Sadly, the two major parties appear to have already gone as far as they are willing to bring the deficit down to current levels. Higher taxes or deeper spending cuts won’t likely be on the table until after this fall’s mid-term elections.

The CBO sums up its recent analysis of the debt situation with a fairly grim conclusion: “How long the nation could sustain the projected growth in federal debt relative to the size of the economy is impossible to predict with any confidence. At some point, investors would begin to doubt the government’s willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money.”

That was a concern expressed a few years ago when the budget deficit reached staggering proportions. Though the size of the deficit has become more manageable, the size of the debt has not. The stock market has learned to ignore this issue, but rising interest rates in 2014 threaten to bring the issue right back to the fore.

Risks to Consider: As an upside risk, the U.S economy may be able to sustain an extended period of GDP growth in excess of 3%, which would help boost tax revenues that can largely offset higher interest expenses.

Action to Take –> How rising interest rates in 2014 impact the perception of this trillion-dollar issue could be a big factor for investors to consider as they make portfolio adjustments. In a worst-case scenario, bond vigilantes could lead to a rapid scare in bond markets, as they did 20 years ago.

That means investors need to avoid becoming too complacent — and should stress-test their investments to be sure that interest-rate risks are manageable. For example, bond funds that own long-duration bonds could prove vulnerable. And yield-producing investments, such as MLPs (master limited partnerships) and REITs (real estate investment trusts), which underperformed in 2013, could see further selling.

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