Hope springs eternally on the stock market. Despite the sharp spike in long-term US Treasury bond yields to multi-decade highs, the stock market seems to party regardless. All the main stock market indices are close to record highs, and equity valuations remain at unusually lofty levels. This suggests that the stock market is operating on two mistaken premises. The first is that the current spike in long-term interest rates will be short-lived. The second is that at a time of the artificial intelligence revolution, persistently high long-term interest rates will only do limited damage to the economy.
In believing that the recent long-term interest rate spike will be short-lived, the stock market seems to be overlooking the parlous state of our public finances and the large amount of maturing government debt. According to the Congressional Budget Office, the Treasury will need to borrow at least $2 trillion a year to cover the budget deficit. That deficit is now running at around 6 percent of GDP even at a time of full employment. At the same time, due to the Treasury’s increased reliance on short-term borrowing, the Treasury will need to roll over around $3 trillion in maturing Treasury bonds and bills each quarter.
The market seems to be overlooking the proliferating signs of waning foreign appetite for our government’s bonds in response to the Trump administration’s freezing of Iranian and Russian dollar deposits and to Trump’s erratic resort to punitive import tariffs even against our traditional allies. Among the signs that foreigners are coming to view the US as an unreliable economic partner have been the $120 billion reduction over the past year in China’s and Japan’s Treasury bond holdings, the Dutch and French central banks’ announcements that they are moving their gold deposits out of New York, and the Norwegian sovereign wealth fund’s announced intention to sell $80 billion of its Treasury holdings.
The last thing that Treasury Secretary Scott Bessent needs is a foreign US government bond buyers’ strike when the government has enormous gross borrowing needs. Underlining this point is the fact that foreigners currently own $8.5 trillion, or around 30 percent of all outstanding Treasuries. Foreigners are very much needed to help finance our gaping budget deficit. Without foreigners adding to their already large Treasury bond holdings, it is difficult to see how long-term US government bond yields are going to come down anytime soon.
If the stock market is overlooking the likely persistence of high long-term US Treasury bond yields, it also seems to be overlooking the many different channels through which those high yields might impact the economy. Among the more important of these channels is that mortgage rates, auto loan rates, and other key borrowing rates are all set off the 10-year Treasury bond yield. We must suppose that the recent spike in the 30-year mortgage rate to 7.5 percent will deliver a body blow to an already weakening housing market. We also must suppose that it will constitute a serious headwind for further AI investment spending, which over the past year has been the main driver of US economic growth.
Beyond its effect on borrowing rates, the spike in long-term Treasury bond yields must be expected to adversely impact the financial system in a variety of ways. The unrealized losses of the regional banks on their large holdings of Treasury bonds will increase, heightening their risk of a deposit run. At the same time, the troubles in the private credit market and the commercial real estate loan market will be compounded as loans contracted at low interest rates will have to be rolled over at considerably higher interest rates.
Looking beyond our borders, our high government bond yields are contributing to the spike in Japanese and European bond yields to multi-decade highs. This could have the effect of triggering another round of the eurozone crisis, this time centered on France, which, ahead of its April presidential election, has unsustainable public finances and dysfunctional politics. In turn, this could have serious consequences for the US and world economies, since France is a much larger economy and has considerably more debt than Greece, whose sovereign debt crisis in 2010 shook world markets.
Even more surprising yet is the market seeming to turn a blind eye to the idea that a stock price’s valuation is supposed to go down as the interest rate at which future earnings are to be discounted goes up. The fact that stock market valuations remain close to record highs despite more than a full percentage point spike in long-term interest rates since the start of the year would seem to be further indication that the stock market is living in la-la land.