If US Treasury yields continue to rise, what will Washington do next?

Karen Brettell

Reuters, October 5 - The U.S. government's borrowing costs are on the rise, and it has almost exhausted the simple means of controlling them.

Long-term Treasury yields are approaching their highest levels in two decades, and the causes do not appear to be temporary. Washington is issuing a large amount of government debt to offset fiscal deficits that have not been reduced. Inflation is cooling only slowly. In addition, even though the real estate and automotive sectors are struggling, the artificial intelligence investment boom is keeping the economy strong enough to prevent interest rates from falling.

The result is that with more than $40 trillion in debt, annual interest expenses alone reach about $1 trillion.

Washington has ways to cope, ranging from greater reliance on short-term borrowing to, in extreme cases, the Federal Reserve capping long-term yields. The deeper policymakers go in implementing these measures, the greater the risk of stoking inflation, which could mean more pain for bondholders in the future.

Torsten Slok, chief economist at Apollo Global Management, said that for every $5 in taxes the government collects, $1 goes to paying Treasury debt. “That's a very, very high number, and it's going to continue rising.”

U.S. President Donald Trump stated in an interview with Time magazine on September 28 that the debt could be repaid through economic growth or inflation, among other ways.

But if those methods fail, the Treasury still has options ranging from moderate to aggressive. At present, the Treasury has relied more on issuing short-term Treasury bills and conducting small-scale buybacks of old debt to help boost market liquidity.

In a worse scenario, the next step would require action by the Federal Reserve. One approach is large-scale purchases of long-term bonds, similar to the “Operation Twist” of 1961; another is to directly set caps on long-term yields, a move not taken by the U.S. since World War II. The more aggressive these measures are, the more they can suppress rates, but at the same time, they carry a higher risk of fueling inflation.

“We are moving to a point where it’s clear the government is uncomfortable with current interest rate levels,” DoubleLine Capital CEO Jeffrey Gundlach said at a recent investment event.

Operation Twist

Based on past experience, the first step in escalation is likely to be a comprehensive revival of “Operation Twist”. This strategy, launched in 1961, flattens the yield curve by selling short-term Treasuries and buying long-term ones.

Substantially implementing “Operation Twist” would require the cooperation of the Federal Reserve, but the Fed may stay on the sidelines unless a clear financial emergency arises. Slok noted that without the Fed’s balance sheet, the Treasury has “very limited resources to lower rates.”

However, Federal Reserve Chairman Kevin Warsh has criticized the Fed’s large holdings of government and other securities, arguing that large-scale bond purchases blur the lines between monetary policy and government debt management.

He called for a new agreement between the Treasury and the Fed, under which the Fed Chair and the Treasury Secretary would communicate publicly on the goals for the Fed’s balance sheet and Treasury bond issuance.

Yield Curve Control

If “Operation Twist”-style purchases prove ineffective, the next step would be explicit yield curve control. In this scenario, the central bank pledges to buy government debt in unlimited amounts to keep long-term yields at a predetermined cap. From 1942 until the Treasury-Fed Accord of 1951, the Fed had set a cap of 2.5% on long-term Treasury yields to help fund World War II and the postwar recovery. The Bank of Japan implemented a variant of this policy from 2016 to 2024.

By artificially suppressing rates, yield curve control eases the political pressure stemming from fiscal deficits. But such a policy only works if investors are not worried that their eventual payments will be in dollars devalued by inflation. Once that confidence falters, the very bond buying meant to suppress yields instead fuels the inflation it was meant to conceal.

Veronique de Rugy, a Senior Research Fellow at the Mercatus Center at George Mason University, stated that ultimately, the only way to solve the debt issue is through spending cuts. “Congress needs to make a fiscal adjustment—in other words, pursue austerity. The Federal Reserve cannot do this alone.”

Diverging Outcomes

John Higgins, Chief Economic Adviser at Capital Economics, points out that since World War II, the U.S. has only twice significantly reduced its debt-to-GDP ratio, with very different outcomes for bondholders each time. After the war, the ratio fell from around 106% of GDP in 1946 to 23% in 1974, while the 10-year Treasury yield climbed from 2.2% to 7.5%. In the 1990s, the debt-to-GDP ratio fell from 48% to 32%, and yields declined as well.

What accounts for this difference? After the war, restrained borrowing costs and relatively high inflation drove nominal economic growth faster than Treasury yields, reducing the debt ratio without the need for strict fiscal discipline. In the 1990s, rates were slightly higher than economic growth, so spending control and rising revenues played the key role.

The current options still follow these two paths: either austerity with falling yields, or financial repression and inflation—meaning yields rise even as the debt ratio improves. Today, mandatory spending makes up a larger share of the budget than in the 1990s, while Congress is unwilling to either raise taxes or cut spending. As a result, Higgins believes the risk “tilts toward” the inflation path, which would harm bondholders.

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