The recent spike in global bond yields has upset many an applecart. Rising government bond yields, which serve as a benchmark for expected returns, have triggered violent sell-offs in risk assets, including precious metals, equities and corporate bonds. The US 10-year Treasury yield has recently touched 5.3%, a level not seen in about two decades, while Japan’s equivalent is at a three-decade high of about 3.1%.

Old-timers who have seen several market cycles have been quick to label this generalised rise in global bond yields a normalisation. They suggest that this is where interest rates are meant to be and that the lows over the past two decades have been the aberration, triggered by the response to the global financial crisis and COVID-19.

On the face of it, this sounds about right.

Indeed, US Treasury yields above 5% do not look particularly high when one squints at the long-term chart. In the three decades before the GFC, the US 10-year yield averaged 7.5% or so, compared with around 2.7% since the crisis. The average across the past five decades is a little above the present 10-year yield of about 5.3%.

But this simplistic conclusion hides a more complex picture. Context is everything, and setting these yields against today’s debt burdens changes the assessment entirely.

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A Tale of Two (Debt) Burdens

In the US, the debt-to-GDP ratio stands at about 120%, while in Japan it is about 220%. The post-GFC average is about 110% for the developed world at large. Before the GFC, the figure was about 57% of GDP. For Japan, which faced its own property and banking crisis in the early 1990s, one needs to go further back to the late 1980s, when its debt-to-GDP ratio was a similar 60%.

In Japan, the rise from 60% to 220% of GDP has taken place alongside GDP that has only doubled since the late 1980s. The absolute value of the debt is now many times what it was, resulting in this rather frightening debt-to-GDP ratio.

Debt Constraints

The picture that emerges is that governments have behaved much like other economic units do, increasing borrowing to take advantage of lower rates. While this is acceptable as countercyclical policy, the opposite must occur if rates normalise or are higher than “normal”.

If interest rates that are now trending towards what the old-timers call “normal” are viewed in this context of debt, the situation is anything but normal. If one assumes that “normal” interest rates should also mean equilibrium debt levels closer to their “normal” pre-crisis levels, then economic units, including governments, should be expected to pay down accumulated debt to sustainable levels. This is where the return-to-normal thesis breaks down.

The severe pullback in spending, the slower GDP growth it would entail, and the resulting deflationary forces would perhaps be even more intolerable for most voter-centric democracies in these nations. Given China’s similar debt problems, it is not clear that one can lay the blame solely at democracy’s door.

It is also far from certain that the debt-reduction goal can be met satisfactorily, even if the adjustment is given considerable time. Greece, for instance, had to institute spending cuts after its debt-to-GDP ratio hit 175% in 2011. Its real economic growth since then has suffered enormously, averaging only about 0.1%. Despite this anaemic growth and the resulting privations, its debt-to-GDP ratio has only declined to about 150%.

It appears that debt-fuelled growth has become business as usual for governments globally. The can has been kicked continually down the road, and the most likely course remains a policy of keeping real interest rates barely above zero. At its core, this is the age-old policy of governments inflating their way out of debt.

Repression Returns

Already, there is talk of the Fed delaying its next hike to December. Verbal and actual interventions by the US Treasury secretary continue, with Bessent explicitly voicing his hope that the Fed keeps an open mind about lower rates and reminding Warsh of his stance on the inflation-lowering effects of AI productivity that got him the job to begin with.

Additionally, investors of all hues have become used to the idea that governments will always stand ready to bail them out in times of distress. Such rescues can be expected to recur, given the large asset-price or credit bubbles associated with this interest rate policy. This is not an unreasonable expectation, given that governments cannot afford long-run deflation in the face of enormous debt, just as it is reasonable to expect property owners to address any threats to their properties’ foundations with alacrity.

Potential bailouts require additional debt beyond business as usual and would require further suppression of interest rates to finance that borrowing. One wonders what would happen to US debt should the AI or private credit bubbles now deflate. Instead of making room to deal with such an eventuality, the US has seen its debt cross $40 trillion.

What does this mean for markets in the medium term? Expect further financial repression, such as the pre-emption of deposits or caps on rates. The backdrop for hard or scarce assets, including land, precious metals and Bitcoin (shudder!), appears bright in such an environment. Equities, which are priced on expectations of nominal returns and can be financed with debt priced below fair levels, should do all right if bought at reasonable prices, though one should expect periodic reversals. In a world where government debt becomes a pervasive worry, India’s apparent prudence, at least going by its debt-to-GDP ratio and its articulated goal of lowering it, together with decent GDP growth, should make some Indian assets attractive.

None of this is new, since it is almost exactly what the last two decades have delivered. Those who see higher rates as simply a return to the old normal fail to account for the size of the debt and the corresponding incentives this creates. The new normal, far from being a reversion to the past, forces a continuation of the playbook behind the low-interest-rate aberration for the foreseeable future. Every basis-point rise in interest rates will now be challenged and debated, while real returns will be suppressed and trust in fiat currencies will likely diminish further.