Why the era of cheap government debt is over

When the world’s largest pension fund changes its investment strategy, the financial world pays close attention, especially when it plans to drastically reduce its holdings of US government bonds. 

According to Reuters, Norway’s sovereign wealth fund wants to cut its US bond holdings — which totaled about $215 billion (€186 billion) at the end of June — by $80 billion.

Global investors are increasingly viewing the debt binge with suspicion, especially as the US’s national debt passed $40 trillion in August. This week, the yield on 30-year US Treasury bonds climbed to nearly 5.4%, the highest level since 2007.

How much debt is too much?

For highly indebted countries such as Japan, where debt exceeds 200% of economic output, borrowing money on capital markets is getting increasingly expensive. The same applies to Italy, France and the UK.

Germany is in a much better position. At around 65% of gross domestic product (GDP), its debt-to-GDP ratio is only about half that of the US.

Borrowing to modernize its armed forces and infrastructure, however, means that ratio is set to move toward 80% over the coming years.

Why US debt keeps rising

The US now spends over $1 trillion annually on interest payments — more than $3 billion per day — according to calculations by the Congressional Budget Office. Since 2024, Washington has spent more annually on servicing its debt than on its entire military. 

The Federal Reserve Bank of St. Louis calculated that the US national debt has risen by around 650% over the past 30 years  from $5.2 trillion in 1996. 

The US budget deficit is on course to reach nearly 6% in 2026. Yet, Treasury Secretary Scott Bessent aims to cut it by half — a goal seen as unrealistic given the huge cost of the Iran war plus a shortfall in revenue due to corporate tax cuts and the tariffs struck down by the Supreme Court.

“That is a very difficult path,” Carsten Roemheld, a capital market strategist at Fidelity International, told DW. “Nervousness is also rising sharply within the US administration — that is clearly evident. If this trajectory continues, it will be very difficult to sustain.”

This is particularly striking when you consider how rapidly US debt is rising.

The $10 trillion mark was passed during the 2008 financial crisis; $20 trillion was reached in 2017. By early 2022, the figure had already hit $30 trillion. It took just four and a half years to reach the next record high of $40 trillion this summer.

Why bond investors are worried

Bessent has resorted to a special measure to drive down US bond yields.

On September 9, he announced that he would triple the volume of long-term US government bond buybacks from the previous $2 billion to as much as $6 billion. 

“The measure is, of course, far too small on its own to truly keep yields in check over the long term,” Roemheld said.

“The bond market 1789486109 demands discipline,” Kim Crawford, global fixed income portfolio manager at JPMorgan Asset Management, told the Financial Times.

That discipline is, however, sorely lacking and many analysts say governments have shown little appetite for spending cuts.

US still dominates capital markets

Despite all the problems, most economists agree that there is currently no way for investors to bypass the United States.

“The European capital market is not yet an alternative to the US market,” Carsten Brzeski, chief economist at ING Bank, told DW. He noted that China and other emerging markets are neither able nor willing to take over this role.

“That is why I believe investors — even though they currently fear higher inflation and question the sustainability of US sovereign debt — will not turn away from the US,” Brzeski said. “At least not as long as the US economy is growing.”

Fidelity’s Roemheld also sees no immediate danger for the United States, which he says is unlikely to default and can simply print money to pay off the debt.

“But this course of action will undermine confidence,” Roemheld said. “And one outlet for this is the dollar exchange rate, which suffers when international investors become less willing to continue providing dollars to the US.”

AI investment drives up interest rates

However long the US war against Iran drags on — driving up military spending and energy prices — there are strong indications that the US will have to pay higher interest rates on capital markets

According to Robert Sockin, chief US economist at asset manager PGIM, this is partly due to artificial intelligence or “AI-related corporate bonds increasingly crowding out government bonds,” as he put it.

Roemheld agrees that as major tech companies issue bonds to finance AI infrastructure they are creating competition for government debt.

“The four major ‘hyperscalers’ alone — the companies building platforms for the US AI industry — have already raised over $800 billion in debt this year, a figure expected to rise further over the next year or two,” he told DW.

This is an attractive alternative for many investors who previously held US Treasuries for safety only to see their outlook deteriorate in recent years, says Roemheld.

If as an investor I can now get “long-term bonds from high-quality companies like Alphabet or Microsoft, sometimes with spreads of 100 basis points over Treasuries, then that represents genuine competition,” he told DW.

This piece was originally published in German.