When Washington Borrows, the World Pays — Until It Doesn’t

US fiscal policy decisions have consequences that cascade through financial markets everywhere. Appreciating the interconnectedness of international capital flows, recognizing the boundaries to borrowing and understanding sovereign risk are issues not unique to economists – they form the basis of doing business in the future. As confidence in Washington’s fiscal prudence wanes, emerging markets — the riskier frontier — may quietly benefit from this global repricing.

In the last few months, we have been witnessing a gradual but monumental shift in the global financial system, centred squarely around Washington’s balance sheet. For decades, the United States wielded almost a divine right to borrow huge quantities at very low rates, and the reason why was obvious: Where else does the world put its money? The dollar reigned supreme, the near-$30 trillion US Treasury market, the absolute safe haven. But this presumption, this implicit trust, is slowly but steadily giving way.

Image: US 10-year (blue) and 30-year (white) Treasury yields; Source: London Stock Exchange Group

The Fiscal Hangover

US President Donald Trump’s ‘big, beautiful bill’ – a 1000-page document recently passed by the House with a narrow 215-214 vote, described a comprehensive tax cut and spending package while raising the national debt ceiling. Whether or not you felt politically aligned with them is immaterial. Their impact on the ledger is unequivocal.

The bill is widely expected to significantly balloon public debt, stoking debate about the ability of the US to pay for its spending. Tack on the chronic budget deficits to this and you have a recipe for unease, particularly at near-two decade high interest rates. It is akin to a company levering up to grow but neglecting whether future cash flow can service the borrowing. Investors, notoriously nervous animals, are beginning to take notice of this increasing leverage.

This is not theoretical angst. The market is providing concrete evidence of stress. US long-term borrowing costs have increased, with the 30-year Treasury yield sitting at its highest in two years. The last time prior to that when it crossed the 5%-mark was during the Global Financial Crisis of 2007-08. The 10-year Treasury yield – the global benchmark for borrowing rates – has climbed to over 4.50%. For context, prior to 2023, the last time it had done so was also in 2007. Yields rise when investors sell bonds, causing their prices to fall.

When long rates rise, paying the pile of debt costs more, exacerbating investor trepidation. Additional fears from Trump’s tariffs re-stoking inflation and possibly leading to a recession has effectively tied the Federal Reserve’s hands. Moody’s joining fellow ratings agencies S&P (2011) and Fitch (2023) in removing the US from its spotless AAA rating is merely piling insult onto injury and further signaling concern over the sustainability of public finances.

As a result, investors have started diversifying away from US assets, in swathes. Led by market-moving hedge funds squaring off large leveraged positions, trade wars, increased debt burdens, an increasing fiscal deficit and Trump occasionally undermining the Feds independence are all undermining confidence in the Treasury market.

The Great Investor Rethink?

Deutsche Banks FX head George Saravelos summed it up starkly following a recent negative response to a US Treasury sale: This is a sign of a foreign buyer strike on US assets. A buyer strike! A potent image – the lifeblood of modern economies, capital, is essentially striking against US debt at current prices. Why? Because international investors are just no longer willing to fund US twin deficits (the budget deficit and the current account deficit) at the prices demanded. Asia is specifically singled out as the principal supplier of this capital. When the dollar drops in tandem with market stress, as it did in the wake of that Treasury sale, it means money is no longer coming into the US in search of safety.

This retreat is more than about bonds alone. And if the increasing cost of capital is emanating from increasing fiscal risk premium, it is difficult to make the case that such a (negative) driver. is good for risk assets such as US equities. The period when the yields moved up in tandem with equities due to soaring growth expectations? That appears to be over and replaced with a more stark reality where fiscal indiscipline has a long shadow.

While advanced economies struggle with the fallout from fiscal largesse, emerging market (EM) economies are stealthily recalibrating their own rate environments. The unwinding out of Treasuries potentially provides backdoor support to the selective EM sovereign debt. If US yields persist at elevated levels based upon concerns over deficits, international buyers will be encouraged to find duration and real yield in soundly managed EM economies with strengthening inflation profiles and credible monetary policy regimes. That said, concurrently the greater directionality of EM front-end rates to US yields — increasingly widespread across world markets since April — means their further repricing in US monetary expectations will ripple through EM assets more intensely than before.

Furthermore, de-dollarisation streams — albeit still early and yet to be buttressed with hard evidence — indicate a slow-moving reallocation direction. JP Morgan in its latest report points out that Japan, for example, began to rotate out of Chinese debt and slightly out of US Treasuries towards European instruments. These sorts of fund inflows will ultimately figure in EMs’ favor, but presently they are fringe beneficiaries in a universe adjusting its financial exposure to US fiscal risk.

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So what is the remedy? Not the Fed, at least not for the root problem. Although extreme market distortions may trigger Fed action such as emergency QE to maintain market operations, this will also not address the root cause and conceivably could prove counter-effective as it fuels inflation expectations. According to experts, only Congress, and not the Fed can remedy this.

The solutions are simple enough, if politically hard to achieve. Either the US will have to sharply revise its existing spending plans to bring forth credibly tighter fiscal policy, or the value of US debt in terms other than dollars will have to drop materially until it is cheap enough to tempt back the foreign buyers. Translation: the government will need to spend less or actually default in real terms (through inflation or devaluation) to make its debt marketable again. Neither is a road anyone wants to travel, but the problem cannot remain ignored as buyers get more choosy.

Macroeconomic stability is clearly no certainty even if you’re the world’s biggest economy. The so-called bond vigilantes are back in town and they’re demanding fiscal responsibility.