The U.S. government is paying more to borrow, and it is running out of easy ways to rein in its borrowing costs. Long-term Treasury yields are near their highest in two decades, and the causes do not look temporary. Washington is selling huge amounts of debt to cover deficits that are not shrinking. Inflation has been slow to cool. And an AI investment boom is keeping the economy strong enough that rates aren’t falling, even though housing and autos are struggling. The result is an interest bill of about US$1 trillion a year on debt of more than US$40 trillion. Washington has ways to push back, from leaning more on short-term borrowing to, at the extreme, having the Federal Reserve cap long-term yields. But the deeper policymakers reach into that toolbox, the greater the risk of stoking inflation, which could mean more pain ahead for bondholders. For every five dollars the government receives in tax revenue, one dollar is spent on servicing the national debt, said Torsten Slok, chief economist at Apollo Global Management. “That’s a really, really high number and that’s just going to continue to increase.” U.S. President Donald Trump said in an interview with Time magazine on September 28 that the debt can be paid off through growth or inflation, among other methods. But if that doesn’t work, the Treasury has other options that range from mild to drastic. It is already relying more on short-term bill issuance and making small buybacks of older debt to help boost market liquidity. In a much worse scenario, the next steps would need action by the Federal Reserve. One would be buying long-term bonds on a large scale, similar to the 1961 Operation Twist. The other would be putting an outright cap on long-term yields, which the US has not done since World War Two. The further down that list policymakers go, the more they can hold rates down, but they would risk making inflation worse. “We’re getting to the point where it’s quite obvious that the government is getting uncomfortable with the level of rates,” Jeffrey Gundlach, chief executive at DoubleLine Capital, said at a recent investment event. Operation Twist Based on what has been tried before, the first escalation would likely be a full revival of Operation Twist. That was the 1961 strategy of selling short-term debt and buying long-term bonds to flatten the yield curve. A meaningful twist would require help from the Federal Reserve, which may hold back unless there is a clear financial emergency. Without the Fed’s balance sheet, the Treasury “has limited resources to lower interest rates,” Slok said. Fed Chairman Kevin Warsh, however, has criticized the Federal Reserve’s large holdings of Treasury and other securities, arguing that large-scale bond-buying can blur the boundary between monetary policy and government debt management. He has called for a new Treasury–Fed accord under which the Fed chair and Treasury secretary would publicly communicate objectives for the Fed’s balance sheet and Treasury issuance. Yield curve control If twist-style buying falls short, the next step would be explicit yield curve control. Here the central bank promises to buy unlimited government debt to keep long-term yields below a set ceiling. The Fed capped long-term Treasury yields at 2.5 per cent to help finance World War Two and the postwar recovery, from 1942 until the 1951 Treasury-Fed Accord. The Bank of Japan ran a version of this policy from 2016 to 2024. By holding rates artificially low, yield curve control eases the political pain of deficits. But it works only as long as investors do not fear being repaid in inflated dollars. Once that confidence cracks, the purchases meant to hold down rates can instead fuel the very inflation they were meant to hide. Ultimately, the only way to fix the debt problem is by cutting spending, said Veronique de Rugy, senior research fellow at the Mercatus Center at George Mason University. “Congress needs to do a fiscal adjustment. Austerity, in other words. The Fed can’t do it alone.” Diverging paths The U.S. has meaningfully cut its debt-to-GDP ratio only twice since World War Two, says John Higgins, chief economic adviser at Capital Economics, and bondholders fared very differently each time. After the war, debt fell from roughly 106 per cent of GDP in 1946 to 23 per cent by 1974, while the 10-year yield climbed from 2.2 per cent to 7.5 per cent. In the 1990s, debt fell from 48 per cent to 32 per cent of GDP, and yields fell with it. What made the difference? After the war, capped borrowing costs and relatively high inflation boosted nominal growth relative to Treasury yields. That shrank the debt ratio without much fiscal discipline. In the 1990s, rates ran slightly higher than growth, so spending restraint and rising revenue did the work. Today’s options follow those same two paths: austerity with falling yields, or financial repression and inflation, where yields rise even as the debt ratio improves. Mandatory spending is now a bigger share of the budget than in the 1990s, and Congress does not want tax hikes or spending cuts. So Higgins sees the risks “tilted toward” the inflationary path that hurts bondholders. --- Reporting by Karen Brettell; Editing by Colin Barr and Edmund Klamann
