Key facts
- US national debt exceeds $40 trillion.
- The US government spends $1 trillion annually on servicing its national debt.
- For every five dollars the government receives in tax revenue, one dollar is spent on debt servicing.
- Operation Twist involves selling short-term debt and buying long-term bonds to flatten the yield curve.
- Yield curve control involves the central bank buying unlimited government debt to keep yields below a set ceiling.
- The US debt-to-GDP ratio fell from 106% in 1946 to 23% by 1974, while the 10-year yield rose from 2.2% to 7.5%.
The US government is facing a significant challenge with rising borrowing costs, as long-term Treasury yields approach levels not seen in two decades. This situation is driven by persistent deficits, slow cooling of inflation, and a strong economy fueled by AI investments, which prevents rates from falling despite struggles in the housing and auto sectors.
The national debt now exceeds $40 trillion, leading to an annual interest bill of approximately $1 trillion. Torsten Slok, chief economist at Apollo Global Management, highlighted the severity, stating that one dollar of every five dollars in tax revenue is spent on debt servicing, a figure expected to increase.
While President Donald Trump has suggested that economic growth or inflation could help pay off the debt, policymakers have other, more drastic options if yields continue to climb. The Treasury is already increasing its reliance on short-term borrowing and conducting small buybacks of older debt to enhance market liquidity.
More significant interventions would require action from the Federal Reserve. These include large-scale purchases of long-term bonds, reminiscent of the 1961 Operation Twist, or implementing outright caps on long-term yields, a policy not used by the US since World War Two. However, these measures carry the risk of exacerbating inflation.
Jeffrey Gundlach, CEO of DoubleLine Capital, observed that policymakers are becoming increasingly uncomfortable with current interest rate levels. The revival of Operation Twist, which aims to flatten the yield curve by selling short-term debt and buying long-term bonds, would likely be the first escalation. However, such a strategy might require Federal Reserve support, which could be withheld unless a clear financial emergency arises, according to Slok.
Fed Chairman Kevin Warsh has previously voiced concerns about the Fed's extensive holdings of Treasury securities, arguing that large-scale bond purchases can blur the lines between monetary policy and government debt management. He has advocated for a new Treasury-Fed accord to coordinate objectives for balance sheet and debt issuance.
Should twist-style buying prove insufficient, the next step would be explicit yield curve control, where the central bank commits to buying unlimited government debt to maintain yields below a specified ceiling. The Fed previously capped long-term Treasury yields at 2.5% from 1942 to 1951. While this policy can ease the political burden of deficits by keeping rates artificially low, it risks fueling inflation if investor confidence in the currency erodes.
Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University, emphasized that the only sustainable solution to the debt problem is cutting spending, stating that Congress must undertake fiscal adjustments. She believes the Fed cannot resolve the issue alone.
John Higgins, chief economic adviser at Capital Economics, noted that the US has only significantly reduced its debt-to-GDP ratio twice since World War II. After the war, the debt ratio decreased substantially while the 10-year yield increased. In the 1990s, both debt and yields fell. Higgins suggests that current options mirror these historical paths: austerity with falling yields, or financial repression and inflation, where yields rise despite an improving debt ratio. Given Congress's reluctance for tax hikes or spending cuts, Higgins sees the risks leaning towards an inflationary path that would negatively impact bondholders.