An American flag in London, Ky., after a tornado passed through the area.Carolyn Kaster/The Associated Press
John Rapley is a contributing columnist for The Globe and Mail. He is an author and academic whose books include Why Empires Fall and Twilight of the Money Gods.
Is the U.S. headed for its own Liz Truss moment?
The term, a legacy of Ms. Truss’s disastrous U.K. premiership, has begun making the rounds in Washington. It refers to the 2022 moment when a tax-cutting, deficit-raising budget convinced bond investors that the U.K.’s leadership had lost its marbles and that it was time to bail on the country. Once they dumped their gilt holdings, prices fell so precipitously that they drove interest rates sharply higher on everything from government debt to mortgage rates. Interest rates on bonds, or yields, move inversely with prices.
The crisis forced Ms. Truss’s resignation, making hers the shortest premiership in British history, all while destroying her Conservative Party’s long-cherished reputation for good economic stewardship. Concerns are now growing that the U.S. might face a similar moment of reckoning. The reason is pretty plain: As things stand, the country’s national debt is expected to reach 166 per cent of GDP by mid-century. However, if Mr. Trump’s “One Big, Beautiful Bill,” which is currently working its way through Congress, reaches his desk, that figure will shoot past 200 per cent.
It gets worse, though. These forecasts rest on the assumption that interest rates stay below 4 per cent. Currently, the yield on 10-year government bonds stands above 4.5 per cent, and the 30-year bond this week briefly crossed the 5 per cent threshold. If these levels persist, they will add a further US$40-trillion to interest costs over the next thirty years, taking U.S. debt even higher.
Mr. Trump is pressuring the Federal Reserve to lower interest rates. Investors, however, are moving the opposite way. Bond rates have been rising steadily since their 2020 trough in the depths of the pandemic, and there’s no reason to expect that trend to reverse, driving the cost of U.S. borrowing even higher.
While U.S. Treasury paper is still considered among the safest investments on the planet, erratic behaviour by the Trump administration has added a new risk premium to U.S. debt, and foreign demand has turned downward. In the meantime, interest rates are rising in other major economies, such as Germany and Japan, giving investors attractive alternatives in markets that are themselves considered equally safe.
The political conversation in the U.S. is now following an eerily similar script to Britain’s in 2022. A week ago, Moody’s joined S&P and Fitch in downgrading U.S. debt. Despite that, House Republicans moved their budget bill to the next stage, insisting that the tax cuts they might end up funding with more borrowing will pay for themselves, since they’ll boost economic growth.
That’s just what Ms. Truss said three years ago. Investors didn’t buy it then, and it’s not obvious they will do so now. Few doubt that Mr. Trump’s tax cuts will inflate the economy. What is harder to believe is that they will generate enough added tax revenue to cover the extra debt. And in the same way Mr. Trump dismisses his naysayers as a deep state opposed to his agenda, Ms. Truss sidelined the budget office that was meant to cost her budget, calling it part of an anti-growth coalition whose opinion could be ignored.
At the end of the day, even the U.S. President can’t bully bond investors into giving him his way. Mr. Trump was already forced to suspend tariffs after his “Liberation Day,” when the bond market voted no-confidence. Now all eyes are on the reaction of investors to his budget bill, but the omens aren’t good. Bond yields continue drifting upward, and Wednesday’s auction of 20-year bonds met a cold response, sending interest rates sharply higher.
If and when Mr. Trump’s bill is passed, what might then happen? Should investors revolt, it‘s unlikely to result in the panicked sell-off that happened three years ago in Britain, when interest rates shot up by a per cent in just a couple of weeks. Ms. Truss’s so-called “moron premium” – the added interest investors demanded to compensate for the risk resulting from inept economic management – was driven quickly higher by some excessive exposure. The consequent forced selling by pension funds then created a spiral of panic. Given the sheer size and depth of the U.S. Treasury market, though, a rise in interest rates there might occur at a more measured pace.
Still, even if the increase in U.S. debt costs was more gradual than the sharp sell-off that happened in Britain, it would drag interest rates up across the board, crimping investment, slowing growth and driving down stock values. The U.S. would thus firmly join the growing club of developed economies that have been stagnating for years, including Canada’s. Funnily enough, too, one effect of such a short-term fiscal stimulus would probably be to prolong the U.S.’s trade deficit, pulling out a key pillar of Mr. Trump’s economic agenda.
So we’re entering a period of high drama, when the relative market calm of recent weeks might give way to renewed fireworks. Grab your popcorn.