After hitting all-time highs earlier this month, the US stock market has settled into a late-summer amble, showing no significant shift in either direction, catching its breath before the next sprint upward. Unfortunately, the other thing that hit a record high was the US national debt, which yesterday crossed the $40 trillion threshold, months earlier than expected.

The two developments are, in fact, closely linked. The US government has poured so much money into the economy over recent years that profits are soaring, with more than half of corporate profits racked up since 2020 funded by the country’s huge and rising fiscal deficits. But that largesse has also raised the US government’s demand for borrowing, which is now running ahead of available supply.

Real interest rates have been rising as a result, which suggests not that investors are concerned about inflation but that they’re starting to worry about the long-term solvency of the American government. More recently, as the AI hyperscalers begin issuing bonds to fund their massive investments in data centers, competition for lenders is adding further fuel to the debt fire.

To help keep things calm, the US Treasury Department has begun meddling in markets. It recently orchestrated a large purchase of yen to keep the currency from weakening to the point at which the Bank of Japan might sell Treasury paper to support the currency. Then, yesterday, the Department announced it would increase its repurchases of long-dated securities, such as the 10- and 30-year Treasury bonds, in order to bring down interest rates at the long end of the curve.

While such micromanagement can alleviate short-term discomfort, it’s like treating cancer with painkillers: the relief can only be temporary. Since the US intervention, the yen has resumed its weakening trend. Meanwhile, although yesterday’s announcement caused interest on the 10-year US bond to fall, rates on short-term paper, such as the one-year Treasury bill and two-year Treasury note, rose. After all, to fund purchases in one corner of the market you have to raise the money in another, and that place is in short-term credit markets.

Assuming inflation remains tame and the AI revolution triggers an increase in economic output, government revenues will improve, and the debt may sort itself out, allowing interest rates to stabilize. So far, investors seem willing to trust in this optimistic scenario. They demand a higher interest rate to lend to the government but aren’t panicking and rushing for the exits. There is therefore no risk of a Liz Truss bond market meltdown moment just now. Investors aren’t about to dump bonds and send interest rates surging, rocking the whole financial edifice.

Still, there are reasons to be cautious. For starters, as long-term investors such as pension funds have scaled back their holdings of government bonds in favor of higher-yielding assets such as private equity, hedge funds have stepped into the breach. America is no exception, with the share of US treasuries held by hedge funds nearly doubling in the last few years. Given that hedge funds tend to use leverage — borrowing in short-term markets to invest in higher-yielding bonds — a sudden rise in short-term rates could force them to sell treasuries in a hurry.

Those short-term rates, in turn, could be driven higher by inflation. With the Iran war in a stalemate and oil prices on the up again, an autumn rise can’t be ruled out. If that happens, markets could once again become volatile. Yesterday’s surge in the gold price suggests some investors may already be preparing for that possibility, seeking early shelter.

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John Rapley is an author and academic who divides his time between London, Johannesburg and Ottawa. His books include Why Empires Fall: Rome, America and the Future of the West (with Peter Heather, Penguin, 2023) and Twilight of the Money Gods: Economics as a Religion (Simon & Schuster, 2017).

jarapley

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