It’s the feel-good story of 2013 that nobody is talking about.

The nation’s budget deficit, which had been spiraling out of control, is finally returning to manageable levels. Thanks to higher government revenues and lower government spending, this year‘s shortfall (for the fiscal year ended Sept. 30) will likely be around 40% lower than a year ago.

In fact, the Congressional Budget Office (CBO) predicts the budget deficit will fall below $400 billion by fiscal 2015. Good news, indeed.

Or is it?

Should we be pleased the budget deficit will still be larger than the entire economy of many mid-sized countries? And for investors, does that falling budget portend good news for stocks and bonds? Before we answer those questions, let’s take a closer look at the road ahead for the U.S. government’s finances.

A Fast-Shrinking Deficit ($billions)

Source: Congressional Budget Office

#-ad_banner-#Despite the current good news, demographic forces threaten to push the deficit higher later this decade. Until policy makers adopt additional measures to raise revenues (likely through tax increases) and cut government spending, the CBO forecasts a $650 billion deficit by fiscal 2019 and an $800 billion deficit by 2022, as a growing pool of retirees absorb a higher amount of retirement and health care benefits. 

How much higher? The CBO notes that Congress is currently spending around $2 trillion every year on mandatory spending such as Social Security and Medicare, though that figure is expected to swell 75% to $3.5 trillion by 2022.

No matter how large or small, the deficit is still troublesome to the rising $16.7 trillion national debt. And all that debt means the government doles out more than $300 billion a year in interest payments on that debt, which plays a role in keeping the budget from coming into balance.

To be sure, the current interest payments actually benefit from the current era of low interest rates. When interest rates start to rise, the government will likely pay much higher sums. Erskine Bowles, who has been leading a government council that seeks to tackle the persistent deficits, paints matters in starker terms:

“We’ll be spending over $1 trillion a year on interest by 2020. That’s $1 trillion we can’t spend to educate our kids or to replace our badly worn-out infrastructure,” said Bowles at a November 2012 forum hosted by IHS Global Insight.

“What makes it doubly bad is that trillion will be spent principally in Asia because that’s where our debt is,” he added.

No matter how you look at it, it remains hard to see how the national debt will stop growing and start shrinking. Even with current low interest rates, the annual interest payments consume more of the federal budget than the Department of Agriculture, Deptartment of Education and Department of State — combined. By next year, interest payments will exceed what the United States spends annually on Medicaid.

Bad For Bonds?
Thus far, the huge tide of deficits and debt has not had much of an impact on bond markets. The global economy has been so weak that investors have gladly bought relatively safe government bonds. But as the global economy strengthens, massive sums of money will pull out of bond funds in pursuit of higher returns, such as stocks.

The drop in demand for bonds means that bond issuers (such as the government, states, municipalities and corporations) will have to offer higher yields. And rising bond yields means falling bond prices, which will lead to a drop in value for that bond fund you may own. Net/net bonds are vulnerable to the ongoing budget deficit, regardless if it’s $1 trillion or $400 billion.

Good For Stocks?
So if investors can be expected to pull money out of bonds and into stocks as the global economy firms, should we read that to mean that budget deficits are good for stocks?

Not at all. In fact, we’re already seeing real headwinds in the economy as government spending shrinks. Uncle Sam provides a lot of juice to the U.S. economy with expenditures in defense, technology, infrastructure and the like. Economists suggest the smaller amount of government spending is already shaving a full percentage point of growth from the U.S. economy’s GDP.

And with the massive debt and deficit pressure still in place, government spending is bound to fall yet further, which means Uncle Sam will be providing an ever-smaller boost to the economy. Net/net stocks have rallied in recent years, despite still-large deficits, but the road ahead will become bumpier as the government shrinks in size. 

Action to Take –> Can Congress ever eliminate the nation’s budget deficit? Where there’s a will, there’s a way, but Washington has lacked the will to do so. In 2012, I suggested ways the government could balance its books. But thus far, only defense spending has been tackled. The other five suggestions have gone unheeded.

Yet until you see Washington finally come to agreements that cut spending and raise revenue, you need to be concerned about bonds and stocks. The recent drop in the annual deficit is great news, but the fact that the national debt is fast-approaching $17 trillion means a debt-triggered crisis can’t be ruled out.

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