Since 2021, our core baseline forecast of the American economy has been framed by what we called the regime change in interest rates.
That is, the era of low inflation and interest rates best defined by insufficient aggregate demand and abundance of supply would be replaced by one illustrated by scarcity of capital, goods, robust demand, inflation and rising rates.
In fits and starts over the past five years, that regime change has altered the trajectory for private equity, private credit and other core financial and professional services that depend on medium- to long-term leverage.
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For a number of reasons, that is now the defining feature of the American and global economies as a secondary and long-awaited discussion on just how much debt is sustainable appears to be moving to the center of the global economic discussion.
When does debt become unsustainable? When the global financial markets say it is.
That appears to be happening.
Yields on 30-year notes in the United States and UK are at their highest levels in two decades, and Japan’s currency has sunk to crisis levels.
In recent days, yields on the U.S. 30-year Treasury hit a multidecade high of 5.3%, in the UK the long bond stands near 5.8%, which is a level not observed since 1998, while comparable debt in France reached 4.9%, Germany 3.7% and Japan 4.1%.
What’s driving the increase?
The energy shock and the threat of rising inflation are important factors, but there is more to it than that. Specifically, governments are spending as if interest rates are still near zero and their economies are in crisis.
While inflation expectations have a direct effect on money-market rates and the yield on 2-year Treasury notes, the effect on longer-term interest rates becomes more muted as investors move further out the yield curve.
Now, long-term interest rates among the advanced economies have moved beyond the 2022 inflation shock levels.
And when the benchmark U.S. 10-year Treasury yield broke above 4.7% on July 31 after years of trading within 4.0% to 4.5% and when the 30-year Treasury bond exceeded 5.3%, it was the bond market showing its concern over deficit spending.
State of play
The risk of rising inflation, concerns about fiscal policy, and competition for scarce capital amid the AI buildout that has modestly crowded out private sector issuance have all contributed to the rise in long-term yields.
But the roots of the increase in yields were years in the making.
Washington now spends 3.3% of gross domestic product to pay for interest on past debt, prompting global investors to demand a higher risk premium.
In addition, the decision by the Federal Reserve and the European Central Bank to pull back on forward guidance, in addition to the credibility problems faced by the Bank of Japan, are contributing to the general unease among investors.
All of this can be observed by looking at the term premium charged by investors to sovereigns to compensate for the risk of holding long-dated paper.
There has been a notable increase in the term premium that investors require to hold long-term Treasury notes.
The term premium for 10-year Treasury bonds is now estimated as 80 basis points, according to the Federal Reserve’s ACM model of interest rate determination, which has experienced a sharp jump since July 2026.
That is an increase of nearly 70 basis points since the April 2025 tariff announcement, with a 23 basis-point increase relative to the November 2025 outset of the current bond market selloff.
Extrapolation out to 30-year Treasury bonds suggests a term premium of 150 basis points, with the range of estimates of 100 to 200 basis points.
That implies at least a full percentage point increase in the risk of holding or writing a long-term bond, with a substantial impact on the cost of maintaining government debt or a mortgage or other long-term investments.
And that in turn has resulted in Treasury strategies like that in the U.S. where the fiscal authority has decided to pull back issuance at the long end of the curve in favor of the short end. That in turn is creating its own set of risks because of the way the hedge fund community profits from the highly leveraged basis trade and swap spread arbitrage strategies that partially rely on Fed repo facility funding.
Thus, the number of permutations and distortions in the market because of risks around the outlook are sending yields higher.
Elephant in the room
The elephant in the room is the rise of economic populism. There is a logic to populism, whether it comes from the right or the left.
Both versions engage in expansionary fiscal policy (tax cuts, higher spending or both), tolerate higher inflation and resist efforts by central banks to achieve price stability.
If such policies go on long enough without a course correction, banking and currency crises tend to follow.
Global investors understand the end game of such policies.
We are clearly not anywhere near a breaking point for these policies, nor are we yet approaching the return of the bond vigilantes.
But investors are expressing their concern by sending long-term yields higher.
What is the appropriate level of debt?
History has shown there is a time and place for deficit spending.
Examples are the deficit spending on infrastructure, education and healthcare that promoted economic activity during the Depression and then after the Second World War.
Most recently, unfunded government outlays during the 2008 financial crisis and the 2020 pandemic maintained household income and spending, and created the basis for the economic recoveries that followed.
In both of those episodes, monetary policy allowed for interest rates that were near zero, making government and commercial spending nearly costless in real (inflation-adjusted) terms once the recoveries and normal levels of inflation took hold.
Interest rates are no longer near zero, however, and the increased cost of debt is adding to the original deficit spending.
When does deficit spending become unsustainable?
Japan’s government debt has been greater than twice the size of its economic output since 2013.
But its accumulation of debt has come at the cost of maintaining its zero-interest rate policy for far longer than it should have, weakening its currency to the point of a crisis.
While strict controls in the euro area have kept government debt at an average of 65% of GDP, debt in the U.S. and UK increased to over 100% of GDP during the pandemic and has increased ever since.
While the accumulation of debt was appropriate during the crises, the bond market is suggesting that not taking constructive policy action decades ago to mitigate it might not have been a good idea.
Can we blame higher interest rates on inflation?
The increase in inflation is certainly playing the major role in the increase in bond yields out to 2-year maturities and to a lesser extent out to 5-year bonds.
As damaging as inflation is to household finances, the IMF expects inflation among advanced economies to peak at 3% in the short term before receding once again to normal levels.
That would preclude inflation approaching the peaks of 2022 and 2023.
Interest rates further out the yield curve are most likely responding to the likelihood of an eventual Federal Reserve action and, more important, to the diminished demand for long-term securities and the increased difficulty of financing additional deficit spending.
The takeaway
The concern over the sustainability of government debt among developed nations is moving to the forefront of investor concerns.
As a result, yields tied to long-term Treasury issuance have increased, which has contributed to a higher cost of capital for businesses of all sizes.
The median cost of sovereign financing among advanced economies has pushed higher to 3.84%, while 30-year government bonds in the U.S. and UK are now in the vicinity of 5.4% and 5.8%, their highest levels in 19 years.
The rising cost of servicing debt seems to have gone unnoticed by policymakers who continue to operate as if long-term interest rates would never move off the zero lower bound.
Equally concerning is the over-reliance on financing long-term debt with short-term securities, which in the face of a liquidity crunch would then send yields on short-term paper soaring.
For investors, the rising cost of debt has created the basis for a bond market selloff, with investors requiring higher returns to cover the increased risk of holding a bond to duration.
