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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is director of international economics at the Council on Foreign Relations and author of “The World That Wasn’t”
As budget pressures intensify in the US, the impact is hitting harder in the Treasuries market. The interest rate on 30-year US Treasury bonds has hit a 19-year high of 5.35 per cent. The piling up, year after year, of historically large budget deficits — currently running at around 6 per cent of GDP — has doubled interest payments as a share of GDP over that period to 3.2 per cent. The annual net interest bill, currently running at more than a trillion dollars, now exceeds defence spending by 16 per cent.
What makes this spiral potentially explosive is that the interest rate demanded by investors to absorb this debt appears not to be a straight linear function of its growth. Instead, more debt seems to accelerate the rise in the rate demanded.
The reason lies in who buys the debt. Nineteen years ago, 76 per cent of US Treasury bonds were held by price-insensitive investors, such as central banks, who bought them more or less reflexively according to their stable reserve-management policies. Today, they hold only 43 per cent.
The majority is now held by price-sensitive investors, such as households and investment funds, which demand greater returns as government debt grows and inflation erodes their purchasing power.
What is driving the shift in investor profile? Central banks that have historically held large amounts of Treasury bonds — China foremost among them — have reduced their reported holdings relative to the growth in US issuance, while diversifying into gold at pace.
Geopolitics has played a part. The weaponisation of the dollar through the growth of US financial sanctions has raised the risks associated with dependence on dollar assets. Japan, meanwhile, has seen its share of the Treasury market fall from 18 per cent in 2004 to 4 per cent purely as a function of slowing reserve accumulation. More broadly, global reserve accumulation has slowed sharply since the early 2000s, when emerging-market central banks were rapidly building their dollar stockpiles.
The upshot is that the issuance of Treasuries needed to finance US debt has been outpacing the demand of these once-reliable price-insensitive borrowers. The new private buyers pay far more attention to yield and have to be offered higher and higher rates to absorb the growing Treasury supply.
The twin problems of surging Treasury supply and stagnant foreign official demand will be exacerbated further still if new Federal Reserve chair Kevin Warsh ploughs forward with his stated ambition of reducing the central bank’s security holdings. The last episode of Fed balance-sheet reduction saw the share of Treasuries held by price-sensitive investors soar by 17 percentage points over 2022 to 2025, while the so-called term premium — the extra compensation demanded by investors to hold long-term debt — rose by 1.1 percentage points. Given the continued increase in price-sensitive investor dominance, further Fed balance-sheet reduction could see yet sharper rises in the price of long-term US debt.
The danger is not merely an isolated bump in borrowing costs. Higher debt-service costs increase the deficit, which requires more issuance, which in turn pushes yet more supply on to price-sensitive investors, who demand still higher rates. Even a modest sustained rise in the average interest rate has enormous fiscal consequences. The Congressional Budget Office estimated that each percentage point rise in rates above its projected path would add $3.2tn to cumulative federal interest costs over the coming decade.
Given this phenomenon, what is the right policy mix? First and foremost, Congress should produce a medium-term debt stabilisation plan requiring automatic spending cuts when debt-to-GDP rises above a defined level. That will give fiscal consolidation some much-needed credibility.
Second, the Trump administration should stop the constant levying of tariffs and sanctions to punish every foreign practice the president dislikes. This petulant indiscipline has encouraged de-dollarisation of the global economy.
Third, the Fed, should it proceed with Warsh’s balance-sheet aims, needs to calibrate the reduction to the size of the gap between Treasury issuance and price-insensitive demand. In practice, this would mean shelving Warsh’s ambitions for now. The Fed can control inflation just fine by setting the interest rate on bank reserves, as it currently does, and should not make the nation’s funding challenges harder than they already are.
