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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is senior strategist at Hudson Bay Capital and former chairman of the Council of Economic Advisers and was a member of the Federal Reserve Board of Governors
Contrary to the assertions of some commentators, the recent rise in interest rates on long-dated US Treasuries is not indicative of financial markets starting to question the soundness of US debt, nor of credibility problems at the Federal Reserve.
To see why, we can divide the yield investors receive into a real component and a component that reflects expected inflation. The most reliable metric of inflation expectations comes from the inflation swaps market, which has been extremely well behaved; inflation expectations are consistent with the Fed’s 2 per cent target at every tenor and across the forward curve. It’s therefore inappropriate to say the increase in yields has anything to do with central bank credibility — that rests entirely on expectations that it will achieve its inflation target, which markets show absolutely no sign of doubting.
By contrast, the real component of the interest rate has moved up. Ten-year real yields are equal to the average expected overnight yield over the next ten years, plus a risk premium that investors demand for locking up their money for ten years. This term premium reflects the fact that realised overnight rates might deviate from expected overnight rates. If the market saw fiscal credibility or debt sustainability problems, this would show up in an increased term premium.
But the term premium has also been stable and is only a hair lower since the end of last year. With term premium and inflation expectations contained, the recent increase in bond yields is therefore almost entirely due to higher expected overnight rates over the long term. In other words, investors are marking up their expectations for long-run economic growth, not becoming concerned over central bank or fiscal credibility. The market could be recognising that AI, deregulation and better tax policy are turbocharging the American economy.
Better growth is great news for the fiscal path. A useful rule of thumb is that one percentage point faster economic growth will reduce deficits by about a percentage point of GDP, because revenues grow faster than outlays and interest payments in a booming economy. Rates have been rising for good reasons, to good effect.
Recently, US deficits have swollen temporarily because of fluctuating tariff rates. In February, before the Supreme Court struck a chunk of them down, tariffs were forecast by the Congressional Budget Office to raise $418bn in 2026, “exceeding corporate income tax receipts for the first time since at least 1934”. What should have been the largest revenue raise in history outside of income taxes turned into a temporary revenue drain as over $100bn in tariff refunds has been paid thus far, causing net tariff revenue to drastically undershoot forecasts.
As the refunds phase out and the administration returns tariff rates to their earlier levels, the revenue will kick back in. Between swinging tariff revenue and better growth, primary deficits will soon start to decline. Many of the same people who complain most loudly about deficits were also the most eager to reject tariff revenue that would reduce deficits.
And as the energy shock from the Iran conflict fades into the background, inflation and interest rates will come down too, cutting the deficit even further. Undoubtedly, there is more work to do on entitlements and reining in wasteful spending. But as tariffs and better growth kick in, long-run fiscal problems are pushed further out.
The long end of the yield curve is the least liquid segment, and August the least liquid month. With deficit reduction around the corner due to tariffs, growth and disinflation, Treasury secretary Scott Bessent is completely right to fight needless volatility by providing additional liquidity, and to resist calls to prematurely term out Treasury issuance by lengthening its maturity. Improved liquidity helps ensure orderly market functioning in the Treasury market, essential for financial stability.
Shorter-maturity debt issuance is the orthodox response to temporarily wider deficits and that response is a key part of regular and predictable debt management. Permanently wider deficits would be a different story, but that’s not the case here. Encouraging unnecessary excess volatility at the long end of the yield curve is the wrong move if the deficit will be coming down. It would be bad for financial markets, bad for American workers and bad for taxpayers.
The US is in a good spot as far as both fiscal and monetary credibility are concerned, and all the signs are that the bond market agrees.
