The recent surge in yields on long-dated U.S. Treasurys has generated concern in some circles. Jamie Dimon, the CEO of JPMorgan Chase, recently warned that the bond market is likely to crack as a result of spiraling government debt levels. “I just don’t know if it’s going to be a crisis in six months or six years, and I’m hoping that we change both the trajectory of the debt and the ability of market makers to make markets,” he said.
Others remain more sanguine and observe that interest rates have in fact normalized close to their pre-2008 global financial crisis levels. In the aftermath of the financial crisis, both real and nominal rates were stuck at unusually low levels for about a dozen years. But, since 2022, we have seen both policy and market rates edge toward their pre-crisis levels.
With interest rates reverting back to their historical norms, is the current wariness surrounding the long end of the yield curve among key investors warranted? To evaluate the validity of such fears, it is worth reviewing recent U.S. fiscal history.
During the past 45 years, the U.S. has had to deal periodically with the “twin deficits” problem — the near-synchronous widening of the fiscal deficit and the current account deficit. In the past, bipartisan policy compromises pushed through by enlightened political leadership have helped America avoid a debt/currency crisis.
In the early 1980s, the Reagan-era tax cuts contributed to a decline in U.S. government revenue that was not offset by cuts on the spending side and this led to a widening of the budget deficit.
Meanwhile, the high interest rates associated with the Paul Volcker disinflation episode led to a sharp appreciation of the U.S. dollar and contributed to a deterioration of the trade and current account balances. This simultaneous deterioration of budget and current account balances gave rise to the twin-deficit hypothesis and highlighted the potential interconnectedness between fiscal deficits and trade deficits.
Emergence of “twin deficits” during the early 1980s generated significant concern in policymaking circles and led to concrete measures on both the fiscal front (in the form of the Tax Reform Act of 1986 and the Budget Enforcement Act of 1990) and on the exchange rate stabilization front (in the form of multilateral agreements such as the 1985 Plaza Accord and the 1987 Louvre Accord).
In the Clinton era, further steps (such as the 1993 Omnibus Budget Reconciliation Act, the reduction in military spending associated with the post-Cold War peace dividend and the 1996 Personal Responsibility and Work Opportunity Reconciliation Act) were undertaken to improve the U.S. fiscal outlook. During the fiscal 1998 through fiscal 2001 period, the federal government even ran budget surpluses.
Concerns regarding the “twin deficits” reemerged during the George W. Bush era as fiscal and current account imbalances worsened. Prior to the 2008 global financial crisis, economists worried that the spike in budget and trade deficits was serious enough to threaten a dollar crisis. Following the collapse of Lehman Brothers in September 2008, however, there was a dollar shortage abroad and the U.S. currency actually strengthened.
Furthermore, as household consumption collapsed and personal saving rate rose, the U.S. current account markedly improved in the post- global financial crisis era. During the Obama era, the 2011 Budget Control Act and the artificially suppressed borrowing costs (via Fed’s quantitative easing and near-zero interest rate policies) helped ease the fiscal burden.
Over the past five years, both the budget and trade deficits have deteriorated sharply. Budget deficits have exceeded 5 percent of GDP since 2020 and projections indicate deficits will remain elevated, raising concerns about fiscal sustainability. Critically, government borrowing costs have risen sharply since 2022. Historian Niall Ferguson has suggested that America’s superpower status may be threatened as the U.S. government now spends more on interest payments than on defense.
Unlike prior episodes, the current cycle of deteriorating external and fiscal imbalances is significantly more worrisome as the country appears to be beset by institutional decay and political ineptitude.
Domestic and foreign investors in U.S. Treasurys are starting to fret about the absence of fiscal rectitude even as government debt-to-GDP ratios reach levels last observed in 1946. Additionally, illogical and inconsistent policies on the trade and foreign policy front raise the prospect of a so-called “moron premium” being applied to U.S. assets.
Legislative threats to tax foreign capital is raising alarm and will likely push up the cost of borrowing even further. Such actions are also fueling concerns about the pre-eminent reserve currency status of the U.S. dollar. Any diminishment of dollar’s exorbitant privilege will affect U.S. fiscal sustainability.
Unlike the 1990s, there is currently no political consensus on reining in fiscal profligacy and restoring fiscal sanity. Harvard’s Ken Rogoff recently noted: “To be sure, this isn’t just about Trump. Interest rates were already rising sharply during Biden’s term. Had Democrats won the presidency and both houses of Congress in 2024, America’s fiscal outlook would probably have been just as bleak. Until a crisis hits, there is little political will to act, and any leader who attempts to pursue fiscal consolidation runs the risk of being voted out of office.”
The late great MIT economist Rudiger Dornbusch once quipped: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” Recent spikes in bond market volatility and long-dated Treasury yields suggest that the moment of fiscal reckoning may finally be approaching.
Vivekanand Jayakumar, Ph.D., is an associate professor of economics at the University of Tampa.