Global investors are sounding the alarm on debt

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 an abundance of supply, would be replaced by one marked by scarce capital and 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.

For a number of reasons, that regime change 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 the UK over the summer reached their highest levels in two decades, and Japan’s currency has sunk to crisis levels.

On Aug. 18, yields on the U.S. 30-year Treasury hit a multidecade high of 5.3%; in the UK, the long bond stood near 5.8%, a level not observed since 1998; and comparable debt reached 4.9% in France, 3.7% in Germany and 4.1% in Japan.

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 were still near zero and their economies were in crisis.

While inflation expectations directly affect money market rates and 2-year Treasury yields, their influence on longer-term interest rates becomes more muted 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% to 4.5%—and the 30-year Treasury bond exceeded 5.3%, the bond market was 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 artificial intelligence build-out 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, along with the credibility problems faced by the Bank of Japan, is contributing to the general unease among investors.

All of this is evident in the term premium investors charge governments to compensate for the risk of holding long-dated paper.

Investors now require a notably higher term premium to hold long-term Treasury notes.

The term premium for 10-year Treasury bonds was 80 basis points on Aug. 18, according to the Federal Reserve’s ACM model of interest rate determination—a sharp jump since July.

That marked an increase of nearly 70 basis points since the April 2025 tariff announcement and 23 basis points since the November 2025 outset of the current bond market sell-off.

Extrapolating to 30-year Treasury bonds suggests a term premium of about 150 basis points, within an estimated range of 100 to 200 basis points as of Aug. 17.

That premium 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.

This shift has, in turn, driven Treasury strategies such as the one 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 approach is itself creating new 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.

The number of permutations and distortions in the market because of risks around the outlook are sending yields higher.

Elephant in the room

The rise of economic populism is the issue that cannot be ignored. There is a logic to populism, whether it comes from the right or the left.

Both forms of populism embrace 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 after World War II.

Most recently, unfunded government outlays during the 2007−09 global financial crisis and the 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 near zero, making government and commercial spending effectively free 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 more than twice 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 signaling that postponing policy action to address it may have been a mistake.  

Can we blame higher interest rates on inflation?

Higher inflation is the primary driver of rising bond yields for maturities of up to two years and, to a lesser extent, five years.

Despite its impact on household finances, inflation in advanced economies is expected to peak at 3% in the short term before receding to normal levels, according to the International Monetary Fund.

That would preclude inflation approaching the peaks of 2022 and 2023.

Interest rates further out on 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.