That will put the squeeze on the debt-heavy Trump administration as it tries to find a path forward for the economy.
It also highlights the tension between the nation's top two economic policymakers. Federal Reserve Chairman Kevin Warsh wants to hear what markets are saying. Treasury Secretary Scott Bessent wants to use his tools to change the message when he believes it's wrong.
Bond yields jumped Wednesday, and were trading near multiple-decade highs Thursday, as traders digested surprisingly positive purchasing managers indexes against the backdrop of a Fed that as of last week has started hiking its short-term policy rate. The 2-year Treasury yield rose 10 basis points to 4.87%, while the 10-year Treasury climbed 17 basis points to 5.12% on Thursday morning.
Those yields are extraordinary by recent standards but less so over a longer horizon. The 10-year Treasury averaged about 5.9% from 1990 through 2006, before years of slow growth and usually low interest rates reset Americans' expectations about borrowing costs.
Now the economy looks stronger, propelled in part by a surge in investment in artificial intelligence. Competition for capital has contributed to higher interest rates.
The boom appears to go deeper. The Census Bureau reported last week that real median household income rose 2.6% to $87,460 and the poverty rate fell by half a percentage point to 10.2%.
The economy's recent strength has also come on the back of a flood of government deficit spending, driven in part by large tax cuts under the first and second Trump administrations, with Iran war spending piling on. The federal deficit is set to come in above 6% of gross domestic product this year, based on data from the Congressional Budget Office. The agency projects that the tax and policy law passed last year will raise deficits by $4.7 trillion over 10 years, though tariffs will offset some of that.
The nation is awash in credit. Warsh pointed to heavy debt issuance by banks and other financial institutions and tight credit spreads — suggesting borrowers have little trouble seeking loans — as among the key factors that prompted him to vote with the rest of the Fed's policymakers to raise interest rates.
In the days since, several other Fed officials, including Governor Michael Barr on Wednesday, said they thought more rate increases would likely be needed.
Bond yields likely benefited from Warsh's decision to raise interest rates this week. Had Warsh not acted on inflation, traders would have run up long-term yields to account for the uncertainty of when and how the Fed might act.
But Warsh will only go so far to influence the 10-year. "Ensuring continuous, sustainable, durable, economic growth, that's the business we're in," he said last week. Warsh and the Fed will act to try to tamp down the risk of inflation, but he doesn't want to induce a recession.
The Fed's decision to move up interest rates highlights the possibility for tension with the Treasury Department.
Warsh treats the 10-year Treasury as a vital source of information about the economy. He called it "the most important asset anywhere in the world" at his most recent news conference. He has changed the way the Fed communicates to make it easier for him to read the market's unfiltered signal.
Bessent, on the other hand, has shown willingness to intervene when he believes markets have moved away from equilibrium. He recently ramped up the Treasury's efforts to buy back some long-term debt maturities because he saw a "fever" in the markets.
"I don't believe that I can change the equilibrium price, but nothing's ever in equilibrium," Bessent said at a Breitbart event on Sept. 8. "When there's a disequilibrium, my job is to try to push things back towards equilibrium," he said.
The stakes are growing because the Treasury must refinance a huge stock of debt while continuing to refinance large deficits. Some in the markets expect the Treasury to cut the supply of long-term debt it issues in favor of more short-term bills.
That can get expensive for the U.S. government, and the taxpayer, when the Fed is raising short-term interest rates.
Higher long-term rates compound the risks. The Committee for a Responsible Federal Budget calculates that the 10-year Treasury at 5% is about 80 basis points above the CBO's baseline. If it stays that way over the coming decade, interest costs would rise to an annual $2.7 trillion — more than Social Security or Medicare, the nonpartisan group said.
Higher average interest rates also mean U.S. growth has to stay higher for longer for the nation to have any chance at growing its way out of debt.
That already looks unlikely. The International Monetary Fund estimated earlier this year that the U.S. government would need to run a primary budget surplus of 1% of GDP to put U.S. debt on a downward trajectory.
With President Donald Trump promising $5,000 checks if Republicans sweep the midterm election, a turn toward fiscal rectitude looks unlikely.
The bond market doesn't care about the politics. It's rendering a verdict about the cost of capital in a strong economy with continuing inflation pressure and vast government borrowing needs.
Policymakers may not like that judgment, but they can't ignore it. %!s()
Image source, AFP via Getty Images