For professional clients only. The information contained within this post is not intended for retail clients.
02 October 2026
The year began with a plausible assumption: if Washington wanted lower interest rates, it would eventually have to borrow less. The arithmetic was straightforward. The harder question was how governments would respond to the constraints it implied.
The assumption was that a major developed economy could not indefinitely run budget deficits of 6–7 per cent of GDP, with unemployment low and inflation still above target, while also expecting lower interest rates. If Washington wanted cheaper money, fiscal policy would eventually have to adjust: reduce demand pressure, ease inflation and give the Federal Reserve more room to cut.
That was the expected bargain. Instead, large deficits have persisted through economic expansion. The Congressional Budget Office projects a deficit of 5.8 per cent of GDP this year, rising to 6.7 per cent by 2036, even with unemployment below 5 per cent.
The arithmetic has not changed. Fiscal policy has proved more persistent, and private borrowers less immediately exposed to higher rates. Households had locked in cheap fixed-rate mortgages, companies had termed out debt and government spending continued to support demand while the Fed tightened.
Government debt is exposed progressively as borrowing matures and deficits require fresh financing. As rates rose, so did Washington’s interest bill. Net interest expenditure is about 3.3 per cent of GDP; CBO expects it to reach 4.6 per cent by 2036. Those payments also provide income to bondholders, partly offsetting the squeeze on borrowers, although how much returns to spending is uncertain.
Inflation fell sufficiently for the Fed to ease. Now it has reversed course and started tightening again.
There is a temptation to read economic resilience as a simple risk-on signal: sell government bonds and buy risk assets. But the conclusion is too neat. Strong growth supports earnings; higher refinancing costs and a larger term premium do not. The question is whether asset prices can tolerate the rate required to restrain the economy.
The debt-interest feedback loop is already under way. Higher rates increase the government’s interest bill; borrowing to meet that bill adds to the debt stock, generating still more interest expense.
Fiscal consolidation could interrupt that loop. If Washington refuses, pressure may increasingly fall on how it finances itself. Issuing more bills and fewer long bonds would reduce the duration investors must absorb. Buybacks could reinforce that shift if financed with shorter-dated borrowing. They would change the maturity of the debt, not eliminate it.
Central-bank purchases would be a separate, more contentious step, requiring the Fed’s participation. Political pressure for cheaper financing does not guarantee its co-operation.
Nevertheless, the incentive is clear. Rising long yields increase mortgage costs, corporate refinancing costs, and the government’s own interest bill. The worse the fiscal arithmetic becomes, the stronger the pressure to contain those yields.
Reducing the supply of duration could leave long yields lower than they would otherwise have been, even with inflation elevated. If inflation also falls while short rates remain restrictive, the case for lower long yields and a flatter curve strengthens. But intervention that undermines confidence in price stability could push the other way.
Deteriorating public finances are therefore not inherently bullish for long bonds. Left alone, they point the other way. The market could become very uncomfortable before policy changes.
But fiscal deterioration may also provoke a response that changes the investment outcome. The assumption was that Washington would reduce the deficit to bring borrowing costs down. If it refuses, it may eventually try to bring borrowing costs down without reducing the deficit.
Either way, the case for owning the long end is stronger than the fiscal headlines suggest.