Oct 5 (Reuters) – The U.S. government is paying more to borrow and lacks simple ways to control its borrowing costs.
Long-term Treasury yields are near their highest level in two decades, and the causes do not appear to be temporary. Washington is selling huge amounts of debt to cover deficits that are not decreasing. Inflation took time to calm down. And the AI investment boom is keeping the economy strong enough that rates won’t fall, even if real estate and autos struggle.
The result is an interest bill of about $1 trillion a year on a debt of more than $40 trillion.
Washington has ways to respond, by relying more on short-term borrowing and, at the extreme, asking the Federal Reserve to cap long-term yields. But the more policymakers dip into that toolbox, the greater the risk of fueling inflation, which could mean even more pain for bondholders.
For every five dollars the government receives in tax revenue, a dollar goes toward servicing the national debt, said Torsten Slok, chief economist at Apollo Global Management. “That’s a really, really high number and it’s going to continue to rise.”
US President Donald Trump said in an interview with Time magazine on September 28 that the debt could be paid off, among other things, through growth or inflation.
But if that doesn’t work, the Treasury has other options, ranging from mild to drastic. It is already relying more on the issuance of short-term bonds and carrying out small buybacks of older debt to help increase market liquidity.
In a much worse scenario, the next steps would require action by the Federal Reserve. One would be to buy long-term bonds on a large scale, as in Operation Twist of 1961. The other would be to simply cap long-term yields, something the United States has not done since World War II. The further down the list policymakers go, the lower they can keep rates, but they risk making inflation worse.
“We’re getting to the point where it’s obvious the government is uncomfortable with where rates are,” Jeffrey Gundlach, managing director of DoubleLine Capital, said at a recent investment event.
OPERATION TWIST
Based on what has been attempted before, the first escalation would likely be a full resumption of Operation Twist. This was the 1961 strategy of selling short-term debt and buying long-term bonds to flatten the yield curve.
A significant turning point would require help from the Federal Reserve, which could 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 vast holdings of Treasury and other securities, arguing that large-scale bond purchases can “blur the line” between monetary policy and government debt management.
He called for a new agreement between the Treasury and the Fed, under which the Fed chairman and Treasury secretary would publicly communicate goals regarding the Fed’s balance sheet and Treasury issuance.
PERFORMANCE CURVE CONTROL
If twist buying fails, the next step would be explicit yield curve control. Here, the central bank promises to purchase an unlimited number of government debt securities in order to keep long-term yields below a set ceiling. The Fed capped long-term Treasury yields at 2.5% to help finance World War II and the postwar recovery, from 1942 until the 1951 agreement between the Treasury and the Fed. The Bank of Japan implemented a version of this policy from 2016 to 2024.
By keeping rates artificially low, yield curve control alleviates the political pain of deficits. But that only works as long as investors don’t worry about being repaid in inflated dollars. Once that confidence deteriorates, purchases intended to keep rates low may instead fuel the inflation they were intended to hide.
Ultimately, the only way to solve the debt problem is to cut spending, said Véronique de Rugy, a senior researcher at George Mason University’s Mercatus Center. “Congress must deliver fiscal adjustment. In other words, austerity. The Fed can’t do it alone.”
DIVERGING PATHS
The United States has only significantly reduced its debt-to-GDP ratio twice since World War II, says John Higgins, chief economic adviser at Capital Economics, and bondholders have had very different results each time. After the war, debt fell from around 106% of GDP in 1946 to 23% in 1974, while the 10-year yield rose from 2.2% to 7.5%. In the 1990s, debt fell from 48% to 32% 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. This reduced the debt ratio without much budgetary discipline. In the 1990s, interest rates were slightly higher than growth, so controlling spending and raising incomes did the job.
Current options follow these same two paths: austerity with falling yields, or financial repression and inflation, where yields rise even as debt ratios improve. Mandatory spending now makes up a larger share of the budget than in the 1990s, and Congress doesn’t want tax hikes or spending cuts. Higgins therefore sees risks as “leaning toward” the inflationary path that hurts bondholders.
Reporting by Karen Brettell; Editing by Colin Barr and Edmund Klamann
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