The Inevitability of Entitlement Reform and Its Impact on Long-Term Treasury Yields

The U.S. fiscal landscape in 2025 is a ticking time bomb. With federal debt projected to reach 166% of GDP by 2034 and entitlement spending consuming over 40% of the federal budget, the pressure to reform programs like Social Security and Medicare is intensifying. These reforms, or the lack thereof, will not only shape the nation’s fiscal health but also dictate the trajectory of long-term Treasury yields—a critical barometer for global capital markets.

The Fiscal Tightrope

The Congressional Budget Office (CBO) estimates that without credible entitlement reforms, annual deficits will balloon to $2.8 trillion by 2034, driven by an aging population and rising healthcare costs [1]. The “One, Big, Beautiful Bill Act” (OBBBA) of 2025 has exacerbated this crisis by extending tax cuts and trimming spending modestly, adding $3.4 trillion to the debt by 2034 [3]. This fiscal trajectory is unsustainable. As the debt ceiling looms again in early 2026, investors are pricing in higher risk, with Treasury yields already climbing to 4.39% in July 2025 [5].

The bond market’s response is twofold: term premium inflation and structural supply shocks. Every 1% rise in interest rates adds $250 billion annually to U.S. borrowing costs, creating a self-reinforcing cycle of higher deficits and yields [1]. Meanwhile, the Treasury’s reliance on short-term debt issuance to manage deficits has reduced the supply of long-term bonds, tempering yield increases but masking deeper fragility [6].

Historical Precedents and Lessons

The 1983 Social Security reforms offer a cautionary tale. By raising the retirement age and increasing payroll taxes, policymakers averted an imminent insolvency crisis, extending the trust fund’s solvency until 2034 [2]. However, these reforms did not address long-term demographic shifts. Today, the worker-to-retiree ratio has plummeted from 5:1 in 1960 to 2.7:1 in 2025, and Medicare’s insolvency is projected by 2034 [4]. Unlike 1983, when reforms stabilized the system for decades, today’s challenges are compounded by a $8.9 trillion debt refinancing need between 2025–2027 at higher rates [1].

The 1983 reforms indirectly influenced bond markets by stabilizing fiscal expectations. Excess payroll tax revenues were invested in Treasury securities, boosting demand for government bonds [1]. However, the current context is far grimmer: foreign ownership of Treasuries has fallen to 24.8% of the total, the lowest since 2003, signaling eroding confidence [1].

The Bond Market’s Calculus

Investors are now pricing in a “bond vigilante” scenario. If Congress delays entitlement reforms, the bond market may demand higher yields to compensate for fiscal risk. A 1 percentage point increase in the U.S. primary balance has historically raised term premia by 11 basis points in subsequent quarters [1]. This dynamic is already playing out: 10-year yields have risen from 1.5% in 2021 to 4.3% in 2025, despite the Fed’s rate-cutting cycle [2].

The Federal Reserve’s hands are tied. With inflation at 2.67% and growth at 2%, the Fed is unlikely to raise rates aggressively, leaving Treasury yields to be dictated by fiscal policy rather than monetary conditions [5]. This creates a paradox: higher deficits require more borrowing, which drives up yields, which in turn increases deficits.

The Path Forward

Entitlement reform is inevitable, but its timing and scope will determine the bond market’s response. Proposals to adjust Social Security’s indexing method (e.g., shifting from wage to price indexing) or raise the retirement age could stabilize the system without triggering a fiscal crisis [2]. However, political gridlock and demographic inertia make such reforms unlikely before 2034, when Medicare and Social Security trust funds hit insolvency.

Conclusion

The U.S. bond market is at a crossroads. Entitlement reform is not just a fiscal imperative but a market stabilizer. Without credible adjustments to Social Security and Medicare, Treasury yields will continue to climb, eroding the U.S. government’s borrowing capacity and triggering a global financial ripple effect. Investors must prepare for a world where fiscal policy, not monetary policy, drives long-term yields—a reality that will define the next decade of capital markets.

Source:
[1] Bond Market Collapse: Signs and Impact on Global Economy [https://discoveryalert.com.au/news/bond-market-collapse-2025-trends-causes-implications/]
[2] Social Security: Today's financing challenge is at least double what it was in 1983 [https://www.brookings.edu/articles/social-security-todays-financing-challenge-is-at-least-double-what-it-was-in-1983/]
[3] Estimating Dynamic Economic and Budget Impacts of Long-term Fiscal Policy Changes [https://budgetlab.yale.edu/research/estimating-dynamic-economic-and-budget-impacts-long-term-fiscal-policy-changes]
[4] The Budget and Economic Outlook: 2025 to 2035 [https://www.cbo.gov/publication/60870]
[5] 10-Year Treasury Yield Long-Term Perspective: July 2025 [https://www.advisorperspectives.com/dshort/updates/2025/08/01/10-year-treasury-yield-long-term-perspective-july-2025]
[6] The 10-Year Treasury Rate: Why Is It Important and What Can Policy Do About It [https://econofact.org/the-10-year-treasury-rate-why-is-it-important-and-what-can-policy-do-about-it]