The credit agency Moody’s just downgraded the US government’s credit rating from AAA to AA1.
The timing couldn’t be worse.
The US government’s 30-year bond yield has already been climbing toward new highs not seen in over 18 years.
At the same time, the new tax bill that just passed is going to widen the US budget deficit, adding fuel to the fire and potentially pushing bond yields much higher.
If government bond yields keep climbing, it will have devastating impacts on the US economy.
Government bond yields are the benchmark for all other interest rates – from mortgage rates that set home prices to corporate borrowing costs.
These moves in government bond yields shouldn’t come as a surprise though.
The US national debt is nearing $37 trillion, with interest payments alone approaching 4.6% of GDP – the highest among developed economies.
Despite this, the US continues running a wide budget deficit.
Now comes what Trump is calling the “Big Beautiful Bill” – a new tax proposal projected to widen the deficit even further, signaling greater treasury bond issuance ahead and potentially causing more upward pressure on yields.
When investors perceive more risk, they demand higher interest rates to compensate.
Think about a company issuing debt – if it’s stable and profitable, it gets low interest rates.
But if investors see high risk, they demand higher rates.
The exact same logic applies to governments.
If investors think the government is spending recklessly and might not pay its debt back, they’ll demand higher interest rates.
That’s exactly what’s happening right now.
But there is one big caveat to all of this, however.
Unlike corporations, the US government issues debt in its own currency – the US dollar.
And the Federal Reserve has the power to print dollars.
So why isn’t the Fed just printing money right now to pay back the government’s debt, which would avoid rising interest rates and economic damage?
Well, it’s not that simple.
This mechanism is called quantitative easing (QE) – when the Fed prints dollars to purchase government debt.
This doesn’t pay the debt back, but it can artificially lower interest rates, making it easier for the government to service its obligations.
The Fed used this in 2008 during the financial crisis and again in 2020.
Both times it helped stabilize bond markets and lower yields to stimulate economic growth.
The question now: should we expect them to do this as rates inch toward 18-year highs?
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The Fed’s Balance Sheet Story
The Federal Reserve’s balance sheet represents the total value of assets they hold, updated every Wednesday.
When this balance sheet expands, like in 2008 and 2011, it means the Fed is buying Treasuries by creating new dollars.
This directly helps lower bond yields, which reduces borrowing costs, supports economic growth, and stabilizes financial markets during stress periods.
But looking at the Fed’s balance sheet today, they haven’t been doing quantitative easing.
They’ve been doing the exact opposite – quantitative tightening.
They’ve been reducing their balance sheet and actually selling US Treasuries, putting upward pressure on bond yields.
Ever since the Fed began shrinking its balance sheet in early 2022, government bond yields have surged in ways not seen since the 1970s.
Why No Fed Intervention?
Everything the Fed does ties back to their dual mandate:
Stable prices and maximum employment.
In other words, keeping inflation low and avoiding layoffs.
Let’s start by looking at inflation.
In both 2008 and 2020, inflation was collapsing.
This gave the Fed room to print dollars and inject liquidity.
But after 2020, inflation surged to 9% in June 2022 from all that liquidity injection.
So, the Fed responded by hiking rates and selling Treasuries to drain liquidity.
This worked as inflation came down significantly since then and is nearly back to the Fed’s 2% target.
So does that mean QE is back on the table?
Not quite…
The Fed doesn’t just look at current inflation but also at inflation expectations – what markets believe future inflation will look like.
They track this through the 5-year breakeven inflation rate, which measures how bond markets price inflation over 5 years.
Historically, the Fed only does QE when inflation expectations are below their 2% target.
Right now, the 5-year breakeven rate holds well above 2%.
So on the inflation side, there’s no signal for QE.
But what about employment?
The chart below shows the US unemployment rate.
According to the Fed, 4-5% unemployment counts as full employment.
Today, unemployment stands at 4.2% – well within their target range.
So, neither the inflation nor employment part of the Fed’s mandate currently points to QE.
We believe the Fed won’t step in just because bond yields are rising.
If they did, it would send a dangerous signal that the Fed is just a backstop for government overspending.
The more plausible path: the Fed stays on the sidelines as higher yields slowly weigh on growth.
We saw this in the 1970s when rapidly rising interest rates triggered economic recessions and unemployment surged.
It’s entirely possible that we see something similar today.
Only then would the Fed react and begin printing money to buy government debt and lower rates.
Until then, we think there’s likely more pain ahead in the bond market.
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