The Fed May Have to Break the Economy to Break the Bond Market

Every time the bond market begins to crack, investors reach for history.

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They point to 2000. They point to 2006. They point to 2016. They point to 2022.

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The charts come out. The comparisons begin. Someone inevitably argues that Treasury yields reached similar levels before and the financial system survived.

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The problem is that nearly all of these comparisons ignore the number that matters most.

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$40.2 trillion.

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That is approximately how much U.S. federal debt now exists.

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In 2000, gross federal debt was roughly $5.7 trillion. By 2006 it was about $8.5 trillion. By 2016 it had risen to almost $20 trillion. At the end of fiscal 2022, it exceeded $30 trillion.
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Today, it is roughly $40.2 trillion.

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That changes everything.

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We Have Seen High Rates Before. We Have Not Seen This Debt Before.

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There is nothing historically extraordinary about a 5% Treasury yield by itself.

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In early 2000, the 10-year Treasury yield moved above 6%. The federal funds rate eventually reached 6.5%. The dot-com bubble burst, economic growth deteriorated and the Federal Reserve was cutting rates aggressively by 2001.

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During the 2004-2006 tightening cycle, the Fed eventually pushed its policy rate to 5.25%. Housing subsequently rolled over, credit conditions deteriorated and the Global Financial Crisis followed.

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But federal debt in 2006 was only about $8.5 trillion.

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Then came 2016.

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Treasury yields surged after falling to historic lows following Brexit. The Federal Reserve later noted that medium and longer-term Treasury yields “rebounded strongly” during the second half of 2016, with another substantial move following the U.S. election. Markets were beginning to price stronger growth, higher inflation and more expansionary fiscal policy.

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Yet the economy did not collapse.

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That episode matters because it demonstrates that rising yields alone do not cause financial crises.

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The underlying balance sheet matters.

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Finally came 2022.

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Inflation exploded, the Fed tightened at extraordinary speed and bonds experienced one of the most violent repricings in modern financial history.

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In a September 2022 Reuters aritcle, Bond bear market: ‘Worst year in history’ for asset as inflation bites, written by David Randall, explained how global bonds had already lost roughly one-fifth of their value.

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Randall described:

“...an accelerating decline in bond markets” as investors confronted inflation and increasingly aggressive central banks.

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The American economy survived that episode too.

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But federal debt was just cresting above $30 trillion.

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Now it is above $40 trillion.

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And the Treasury market is once again testing levels that would have been considered deeply restrictive throughout most of the post-financial-crisis era.

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This is where historical analogies start becoming dangerous.

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The Interest Expense Is the Story

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The Congressional Budget Office's February 2026 projections already looked uncomfortable.

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CBO projected federal net interest expense rising from approximately $1 trillion in 2026 to $2.1 trillion in 2036.

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According to the Congressional Budget Office, “The Budget and Economic Outlook: 2026 to 2036”, interest expense would climb from 3.3% of GDP to 4.6% and, by 2036, would nearly equal the entire federal discretionary budget.

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But that is where the story gets considerably more interesting.

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On September 24, CBO published a new analysis examining what would happen if interest rates persistently ran just one percentage point higher than assumed in its extended baseline.

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The result was extraordinary.

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CBO estimates debt held by the public would reach 222% of GDP by 2056, compared with 175% under its extended baseline.

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That is a 47-percentage-point deterioration from a persistent one-point increase in rates.

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Source: Congressional Budget Office, Projections of Deficits and Debt Under Alternative Scenarios for Interest Rates and the Budget.

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One percentage point.

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That is all.

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Now consider a deliberately simplified exercise.

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Take today's roughly $40.2 trillion gross federal debt and apply different interest rates across it.

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• At 4.1%, annual interest would theoretically equal about $1.65 trillion.
• At 5.1%, it becomes approximately $2.05 trillion.
• At 6.1%, approximately $2.45 trillion.
• And at 10%, it jumps to $4.02 trillion per year.

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To be clear, that is not a forecast of federal interest expense. And, keep in mind, that would be at today's debt levels. Every year that goes by, the debt compounds and the number soars. That is why by 2036, even at 4.1% the CBO is forecasting annual interest payments to increase to $2.1 trillion.

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Treasury debt does not reprice overnight. Securities mature at different times, different instruments carry different rates, and the federal government's reported net interest expense is calculated on debt held by the public rather than simply multiplying gross federal debt by a single market yield.

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But the exercise demonstrates the sensitivity.

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Higher rates gradually work their way through the government's balance sheet as maturing debt has to be refinanced.

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The damage arrives with a lag.

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What If the Fed Has Lost Control of the Long End?

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The Federal Reserve controls an overnight policy rate.

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It does not dictate the 10-year Treasury yield.

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Long-term yields incorporate expected inflation, expected future monetary policy, economic growth, Treasury issuance, fiscal credibility and the extra compensation investors demand for holding long-duration debt.

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That distinction is becoming extraordinarily important.

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Reuters article Bond market woes likely a factor for Fed, but intervention seen as unlikely, by Michael Derby, recently examined the possibility that rising Treasury yields could eventually begin influencing Fed decisions.

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BlackRock's Rick Rieder, one of the world's most influential bond investors, told Reuters:

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“One of the Fed's unwritten mandates is financial conditions.”

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Rieder added that the cost of debt:

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“...has to be part of the criteria they consider.”

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when setting monetary policy. That is an important observation. These levels of interest have not only entered the conversation, they are the conservation.

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But another recent Reuters article As 5% Treasury yields lose shock value, investors start worrying about 6%, by Marc Jones and Naomi Roynick, suggests investors may be becoming almost too comfortable with yields that would once have terrified them.

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BlueBay Asset Management's Mike Bell cautioned against treating any particular yield as an automatic breaking point:

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“It's a relative number, not an absolute number.”

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There is no magical Treasury yield where the economy automatically collapses.

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I agree.

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But that is precisely why today's situation may be more dangerous than previous episodes.

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The problem is not simply that the 10-year Treasury reaches 5% or 6%.

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The problem is 5% or 6% interacting with $40 trillion of federal debt, persistent deficits, enormous refinancing requirements and a government still adding trillions of dollars to its obligations.

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The absolute number matters less than the balance sheet it is being applied to.

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The Fed May Have to Destroy Demand

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There are ultimately only a handful of ways long-term Treasury yields fall sustainably.

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Inflation can fall.

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Economic growth can deteriorate.

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Washington can dramatically improve its fiscal position.

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Or the Federal Reserve can intervene aggressively in the Treasury market.

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That final option sounds easy.

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It isn't.

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If the central bank begins purchasing enormous quantities of bonds specifically to suppress long-term yields while inflation remains elevated, investors could interpret the policy as monetary financing of government deficits.

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That could raise inflation expectations rather than lower them.

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Chicago Fed President Austan Goolsbee addressed almost exactly this dilemma last week. In Reuters article, Goolsbee rejects idea of Fed cutting rates to help US finance its debt, by Howard Schneider, he described the idea of forcing rates lower because government debt is becoming too expensive.

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He warned that such a strategy could ultimately backfire if inflation expectations rose and markets demanded even higher long-term borrowing rates.

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That gets directly to the dilemma.

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If the Fed has truly lost control of the long end of the bond market, printing money to buy Treasuries may not solve the fundamental problem.

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It could make it worse.

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Which leaves another path.

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The Fed may have to weaken the economy enough that inflation expectations finally collapse.

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Not talk inflation down.

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Not forecast it down.

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Crush demand enough that markets believe inflation is going down.

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That could mean weaker consumption, slowing corporate investment, deteriorating employment, falling commodity demand, tighter credit creation and ultimately recession.

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In other words, if the bond market no longer believes incremental tightening is sufficient, the Fed may eventually have to prove it.

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The cure for 5% or 6% long-term yields could be an economy weak enough that investors suddenly become desperate to own long-duration Treasuries again.

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That is the paradox.

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The government can no longer comfortably afford persistently high rates.

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But attempting to artificially suppress those rates before inflation is genuinely defeated could undermine confidence further.

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And Then There Is Gold

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Precious metals add another layer to this story because their reaction to rising bond yields has historically been anything but uniform.

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During 2006, for example, gold gained roughly 23% while silver surged approximately 46%.

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In 2016, another year containing a significant late-year Treasury selloff, gold gained around 8% and silver approximately 15%.

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During the brutal bond market of 2022, gold finished almost flat in dollar terms while silver actually gained roughly 3%.

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The lesson is important.

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Gold does not simply rise because bond prices fall.

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Initially, rapidly rising real yields can be hostile to precious metals because investors suddenly have an attractive yield available from government bonds.

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But something changes when rising yields stop representing economic strength and begin representing fiscal risk.

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Gold's competition is not merely the Treasury yield.

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It is confidence in the institution issuing the Treasury.

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That distinction could become increasingly important.

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The World Gold Council in Why gold in 2026? A cross-asset perspective has also highlighted gold's tendency to behave differently during episodes of serious market stress, including both the Global Financial Crisis and the 2022 inflation shock.

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This Is Not Another Normal Rate Cycle

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There is seductive comfort in historical charts.

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Six-percent Treasury yields existed before.

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Central banks have defeated inflation before.

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Bond markets have crashed before.

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Economies have survived them.

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All true.

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But America did not owe $40 trillion during any of those episodes.

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CBO's own work now demonstrates how sensitive the long-term fiscal trajectory has become to even a one-percentage-point increase in interest rates.

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That means the next phase of this bond market may not resemble 2000, 2006, 2016 or even 2022.

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Those episodes can teach us how markets behave.

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They cannot tell us how a $40 trillion sovereign balance sheet behaves when the world's benchmark interest rate refuses to come down.

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If inflation remains sticky and Treasury investors continue demanding greater compensation for lending money to Washington, the Federal Reserve could eventually face a brutal choice.

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Tolerate higher long-term borrowing costs and allow America's fiscal arithmetic to deteriorate further.

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Attempt to suppress yields and risk undermining inflation credibility.

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Or tighten financial conditions until something breaks badly enough that inflation, demand and bond yields finally collapse together.

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The uncomfortable possibility is that the bond market is now demanding something policymakers have spent decades trying to avoid:

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a real recession.

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And this time, the United States enters that battle carrying more debt than at any point in its history.

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