Interest Rates, Debt and the U.S. Outlook: Unpacking the Bond Yield Surge

The forces pushing them up are tangled — stubborn inflation, oil, tariffs, a new Federal Reserve chair and a national debt that keeps outgrowing the economy.

Vikram Kumar, professor of economics at Davidson College, says how you feel about the situation depends on where you sit.

"As a consumer, I worry a little bit,” he said. “As a saver, I'm on the happy side."

Here, he talks about what's pushing long-term interest rates higher, how the national debt figures in, and why he remains "generally bullish" about the U.S. economy.

What’s behind the spike in bond yields?

There's uncertainty about inflation, uncertainty about the course of monetary policy, uncertainty about supply chains, oil, tariffs, AI and national debt sustainability. Technically, both inflationary expectations and the term premium are behind the spike in long-term interest rates.

It's an idiosyncratic confluence of factors buffeting the bond market today, which is what makes it very different from prior interest rate shocks. On the surface, it's another very rapid increase in interest rates, but behind it, the factors leading up to it are quite different from the past.

The national debt recently crossed $40 trillion; that’s up $17 trillion since 2020, and the CBO projects it will reach roughly $64 trillion within a decade. How does that affect the bond market?

When the government runs deficits, it borrows funds in the bond market by selling bonds. That lowers the price of bonds. Because bond prices and interest rates are inversely related, the interest rates rise. Stated differently, the government is competing with other borrowers for loanable funds. The more the government borrows, the greater the competition for funds — everybody has to pay a higher interest rate.

The bond market is unusually competitive at the moment. Part of the increase has been driven by an incredibly large issuance of private debt by companies like Meta that are hyperscalers in the AI world. They are investing trillions of dollars for data center buildouts, which is adding to the interest cost for the U.S. Treasury because the government is competing with those firms.

Interest rates are also likely signaling the bond market’s concern about the sustainability of a large and rising debt relative to our GDP — this concern rises when the interest rate exceeds the economic growth rate.

Is this a U.S. story or a global one?

It's a global issue now — sovereign debt issues have increased around the world. The United Kingdom, Japan, France and Germany have seen record increases in interest rates in the past month. It's a signal to policymakers and to politicians to fix their fiscal houses. 

Higher oil prices and inflationary expectations and anticipated central bank tightening have investors demanding larger term premiums for holding long-duration debt. The fiscal situation only amplifies their concerns.

Governments have three options to control the debt outlook: raise taxes, lower spending or increase the rate of growth so that they can afford to service the debt. The U.S. is fortunate to have higher growth than Europe right now, so we can increase our tax revenue base. 

How does this compare with past interest rate shocks?

Sudden large increases have happened before, but we are not as well positioned right now because of the size of the national debt. In the 1970s, interest rates went up a lot, but at that time inflationary expectations were getting unanchored. That is not a worry right now. Inflationary expectations are higher than optimal, but they are tethered. In the mid-1990s, the Fed increased rates very rapidly during the “Great Bond Massacre,” but then the national debt was much lower and inflation was not a factor. 

Interest rate shocks like this can have unintended consequences. In 2022, when the Fed increased interest rates very quickly to combat inflation, it had unforeseeable repercussions — ultimately resulting in the failure of Silicon Valley Bank and Signature Bank, for example. 

Are foreign investors backing away from U.S. debt? Is the dollar losing its status as the reserve currency?

There was a recent news item about the Norwegian sovereign wealth fund trying to move away from its dollar holdings. But on the whole, the inflow of foreign funds into Treasuries has been quite stable. The latest Treasury International Capital data for June showed healthy foreign inflows into Treasuries, from both private and public sources. Foreign holding of the national debt had declined significantly in the last decade, but for the last six years it has also been fairly stable. To me the data doesn't indicate reduced interest in U.S. dollar debt.

Of course, the U.S. has to be careful to not undermine its privilege or status as a reserve currency. The dollar's share in global foreign exchange holdings is pretty healthy and stable. I think the Dollar Buyers Club hasn't blackballed the dollar, though some members of that club are trying.

How are you feeling about the economy overall?

I'm generally bullish about the U.S. economy, cautiously so. I have reason to be if one looks at the data itself. The U.S. economy has been growing very well, and though the inflation rate is not ideal, the job market has not broken despite a lot of the challenges. The U.S. economy has defied the odds before.

That doesn't mean there aren't problems. Wage growth is not yet outpacing inflation, so people are not feeling very happy. On the other hand, asset markets are doing really well. How one feels depends upon where in the spectrum of the economy one sits. So I am not Pollyanna-ish about it. But the U.S. is an economy from which you can expect reasonably good outcomes.