This Is Probably Fine

TITLE: This Is Probably Fine! CHANNEL: Patrick Boyle DATE: 2026-05-29 ---TRANSCRIPT--- Over the past few weeks, people who trade government debt for a living have become somewhat agitated. On May 19th, the yield on 30-year US treasuries hit 5.2%. The highest level since July 2007, a time when the global economy was doing absolutely spectacularly, and nothing bad was about to happen whatsoever. The US Treasury auctioned $25 billion of 30-year bonds earlier that same week at just over 5%. Analysts at HSBC have taken to describing yield levels like these as the danger zone, which is their term for the point at which borrowing costs get expensive enough to start breaking things in other parts of the financial system, which is broadly speaking not what you want to see happening. This is not exclusively an American problem either. Long-term borrowing costs in Canada, France, Spain, Portugal, and the Netherlands have all risen sharply. In the United Kingdom, 30-year gilts are yielding around 5.5%. Levels not seen since 1998.

Japan’s 20-year bond yields have climbed to around 3.6% which is remarkable given that Japan spent most of the last 30 years trying to generate any inflation at all with no real luck until recently. Germany’s 30-year bonds are sitting at around 3.5%. The German government currently expects its economy to grow by about half of a percent this year. Committing to pay out seven times your expected growth rate in interest is generally considered a suboptimal financial arrangement. But anyhow, the catalyst for all of this is the ongoing conflict in Iran. The closure of the strait of Hormuz through which roughly a fifth of global oil supply normally travels has pushed fuel prices sharply higher which has pushed up costs for pretty much everything that moves on a truck which is most things. US petrol or gas as they call it is now $4.51 a gallon. Diesel is close to record levels. The inflation data has duly followed. US CPI rose to 3.8% in April. The producer price index, which is basically inflation for the companies making the things that you eventually buy before the cost gets passed along to you, came in at 6%, its highest reading since the energy shock of late 2022. Airline tickets cost considerably more than they did last year, which is particularly impressive given that the airlines have simultaneously managed to reduce legroom to dimensions previously only seen in a clown car. This is what the industry calls yield management. Passengers tend to call it something else. Bond investors have always had a complicated relationship with inflation. The technical term for what they feel about it is hatred. If you lend someone money for 30 years and they spent the intervening period printing a lot of it, you’re not going to be happy. Markets are increasingly waking up to the idea that the era of essentially free money is probably over. The trade friction, supply chain disruption, and populations aging faster than governments are willing to admit are all pushing in the same inflationary direction. Investors are also beginning to wonder gently whether politicians have any real intention of paying down the debts that they accumulated during the pandemic or whether the plan is simply to keep rolling them over and hope no one asks. A recent Bank of America survey found that 62% of fund managers now expect US 30-year yields to reach 6% before the year is out. That would take us back to 1999. So that sounds good. To understand how we got here, it helps to understand how politicians and central bankers have historically dealt with each other, which has on at least one occasion involved the president of the United States physically assaulting the head of the Federal Reserve. But before we dig into that, let me tell you about this week’s video sponsor, Incogni.

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Now, before we all agree that civilization is ending, it’s worth pausing. Writing in the FT, Robert Armstrong made the rather sensible point that the latest data doesn’t fundamentally rewrite the story of the American economy. It mostly just confirms that inflation hasn’t fully gone away yet. Stuart Kirk has argued that as long as a country has a credible central bank, the sheer size of its national debt shouldn’t necessarily drive long-term yields dramatically higher, as we’re probably not yet at the point where anyone needs to worry about actually being repaid. We might be at the point where people worry about what the money will be worth when they are, which is a different problem, but still not great. So, what we’re probably watching is not a collapse. It’s an adjustment. Uncomfortable, expensive, and probably affecting your mortgage, but an adjustment nonetheless. Bond investors are looking at governments and asking a fairly simple question. Do we actually trust you? And governments, broadly speaking, are taking their time with the answer. When the cost of long-term borrowing goes up, a few things tend to happen in markets. For one thing, capital starts to drift away from equities. If you glance at the major indices right now, things might look relatively calm on the surface, but the mechanics underneath are behaving a bit strangely. Market breadth has recently collapsed. Recent analysis from the FT suggests that if you exclude companies connected to artificial intelligence, the broader stock market has been roughly flat for about a month. Approximately 94% of recent S&P 500 gains have come from a very small number of tech giants. The issue here is fairly straightforward. The technology companies currently holding the market up are in many cases genuinely enormously profitable today, funding their AI infrastructure out of their own cash reserves along with some new borrowing, which is genuinely quite impressive. Their multi-trillion dollar valuations, however, rest on the assumption that they will generate even larger, more spectacular piles of cash five or 10 years from now. When the US government is offering a guaranteed 5% return today, those distant future earnings become mathematically less compelling. It doesn’t mean that the whole thing falls over. It just means that the gap between what these companies are worth and what investors are paying for them has to keep growing to justify itself, which it may or may not do. We’ll have to see. Meanwhile, higher rates filter through to the real economy in the usual ways. Mortgages get more expensive. The housing market freezes. People direct more of their monthly income towards servicing existing debts, which leaves them with less to spend on other things like new cars, holidays, overpriced snacks, the usual casualties. There is also a rather delicate situation developing in corporate lending, particularly in private credit. A large volume of business borrowing in recent years was arranged with floating rather than fixed interest rates, which was fine when rates were low and is somewhat less fine today. Highly indebted companies could find themselves watching their financing costs rise at exactly the moment their revenue growth is slowing. This is generally not considered an ideal sequence of events. The biggest borrower of all is of course the government. US interest payments on the national debt crossed a trillion dollars for the first time in 2024 and have kept going. That is now more than the United States spends on defense. The historian Niall Ferguson in a paper he has named with characteristic modesty, Ferguson’s law, argues that any great power that spends more on debt service than on defense risks ceasing to be a great power. The United States crossed that threshold last year. So that’s something to keep in mind. The good news, and there is good news, is that none of this is necessarily a disaster. People have been predicting the collapse of the US bond market for a long time, and the people doing the predicting have not on the whole covered themselves in glory. The bond market has a way of humbling everyone who tries to call its turning points, which is a part of what makes the current situation so interesting. To understand why this moment feels different, it helps to understand what has been happening in bond markets over the past 40 years and also what happened before that. Because the situation we’re currently in was in fact the normal situation for most financial history. And the abnormal part was the bit we all rather recently got used to.

Historically speaking, politicians and central bankers don’t naturally get along. Politicians generally want interest rates to be as low as possible. Ideally low enough that the economy is running hot or possibly on fire right around the time people go to vote. Central bankers are unfortunately required to occasionally ruin this arrangement by raising rates before money loses its value entirely. This is not a role that makes them popular with politicians. In the United States, the Federal Reserve is formally independent, which means politicians are not supposed to meddle with it. They have, however, over the years found creative ways to express their views. Take Lyndon B. Johnson. LBJ was a famously colorful character, a man who regularly conducted cabinet meetings from the toilet and who is preserved on White House audio tapes calling the Hagar clothing Company to order new trousers specifically requesting, and I’m quoting directly here, more room in the crotch down where your knots hang while audibly burping throughout.

In 1965, with the US economy running hot from Vietnam war spending and various domestic programs, Fed Chairman William McChesney Martin raised interest rates. LBJ was not pleased with this. He summoned Martin to his ranch in Texas where the president of the United States allegedly shoved the head of the central banker against his living room wall and shouted, “Boys are dying in Vietnam and Bill Martin doesn’t care.” Which is one approach to monetary policy discussions. A few years later, Richard Nixon faced a similar problem. Terrified that a recession would cost him the 1972 election, he pressured his Fed chairman, Arthur Burns, into keeping rates artificially low. The strategy worked flawlessly for Nixon’s reelection campaign, but it helped ignite a decade of catastrophic double-digit inflation. Burns has since acquired the reputation as the worst Fed chair in history, which is the sort of legacy that tends to outlast the praise he would have gotten from the president. Nixon, of course, had other things to worry about by then. This all brings us to Paul Volcker, who was appointed in the late 1970s with inflation completely out of control. Volcker was 6’7, smoked cheap cigars, and essentially did not care whether politicians were angry with him or not. To break inflation, he hiked the federal funds rate to 20%. It was a brutal remedy. The construction industry effectively shut down overnight. Angry homebuilders mailed 2x4s to the Federal Reserve in protest. Auto dealers mailed in unsold car keys. Apparently, Volcker kept the lumber and it’s now in the Museum of American Finance, which is where it belongs. There is an argument, though, that Jay Powell should have used some of it in the building renovations to keep the costs down. In 1984, Ronald Reagan’s chief of staff, James Baker, reportedly ordered Volcker not to raise rates before the upcoming election. Volcker ignored him. He caused a severe recession, broke the back of inflation, and ushered in four decades of broadly falling interest rates and relatively calm bond markets. People today occasionally ask why a modern central banker doesn’t simply pull a Volcker, hike aggressively, and break the fever. The answer comes down to arithmetic. When Volcker hiked rates to 20% in the early 1980s, US national debt was roughly 30% of GDP. The treatment was painful, but the government could still afford the interest bill. Today, the Congressional Budget Office projects that American public debt will climb from around 101% of GDP now to 120% by 2036, driven by what the Kato Institute has described as a European level of public spending combined with an American level of taxation. That level of public debt would exceed even the record set just after the Second World War. If a central bank hikes rates aggressively when a government is carrying the amount of debt they’re carrying today, the interest payments alone can blow up the national budget. Economists refer to this as fiscal dominance, the point at which a government owes so much that the central bank effectively loses its independence in practice because raising rates enough to cure inflation would simultaneously make the national debt unpayable. It’s a difficult position for a Fed chair to be in. Technically, the central bank is still independent. It just can’t actually do the thing that independence is supposed to allow it to do. Now, the United States has one considerable advantage in this situation. It issues the world’s reserve currency and operates the largest bond market on Earth. If you are a global investor, it’s very difficult to avoid American debt entirely. There simply isn’t enough of anything else to buy. Other countries don’t enjoy this luxury. The United Kingdom is a useful illustration of what this looks like in practice. Its bond market is significantly smaller, which makes it considerably easier for international investors to simply step away if they don’t like what they see.

In October 1973, Egypt and Syria launched a surprise military assault on Israel during Yom Kippur. When the United States and other Western nations provided support to Israel, the Arab members of OPEC retaliated with an oil embargo. Crude prices quadrupled in a matter of months. For the United Kingdom, this arrived at a particularly awkward moment. The government was already struggling with sticky inflation and the National Union of Mine Workers decided that a global energy shortage was an excellent opportunity to implement a strict overtime ban. Prime Minister Edward Heath responded by declaring a state of emergency and introducing a 3-day working week. Commercial electricity was rationed to three specified days. Television networks were legally required to stop broadcasting at 10 at night, which gave the British public plenty of time to sit in the dark and reflect on the absolute triumph of their government’s energy policy. There was an excellent series on the Rest is History podcast covering this era called Britain in the 70s, which I’d highly recommend to anyone wanting to understand just how bleak things actually got. But anyhow, speed limits were cut to 50 miles per hour. Building temperatures were legally capped. Heath eventually called an election, running under the slogan, “Who governs Britain?” And the public collectively decided that it wasn’t going to be him. By 1975, UK inflation peaked at around 24%. At that rate, the purchasing power of your savings is roughly halved every 3 years. Currency markets took one look at Britain’s situation and began selling sterling. By 1976, the pound was falling fast enough that Prime Minister James Callaghan had to go cap in hand to the IMF for an emergency bailout, which came with the usual painful conditions attached. It was a significant blow to national pride given that the British had helped design the IMF at Bretton Woods in the first place. It’s the economic equivalent of having to borrow money from your younger brother to pay for your own birthday dinner. Then came the winter of discontent. By 1978, public sector unions rejected the government’s wage caps and walked out. Lorry drivers struck, refuse collectors struck, gravediggers walked out, leading to entirely accurate newspaper reports of the dead remaining unburied in the streets. When Callaghan returned from an international summit in the Caribbean and told journalists he didn’t see the domestic situation as one of mounting chaos, the press condensed his actual remarks into the immortal front page, crisis, what crisis? He lost the subsequent election and the post-war economic consensus ended more or less on the spot. Now, to demonstrate that these episodes are entirely timeless, we can skip forward 50 years to September 2022. A newly appointed prime minister named Liz Truss, you may not remember her, and her chancellor Kwasi Kwarteng unveiled what they called a mini budget. It contained 45 billion pounds of entirely unfunded tax cuts delivered in the middle of a global energy crunch with British inflation already running above 10%. The bond market did not take weeks to consider its response. It reacted in roughly 10 minutes. Sterling collapsed. Long-term gilts spiked so violently that the market for British government debt briefly ceased to function. A risk-management structure used by pension funds called liability-driven investment, which had been designed in theory to reduce risk, got caught in a doom loop. As bond prices fell, pension funds faced sudden margin calls. To meet those margin calls, they sold more bonds, which drove yields higher, which triggered more margin calls, which required more bond sales. The Bank of England had to launch an emergency bond purchasing program simply to stop the nation’s financial plumbing from seizing entirely. Truss resigned after 44 days. She was famously outlasted by a lettuce from Tesco that cost 60p wearing a blonde wig that the Daily Star had placed next to a framed photograph of her and live streamed continuously to see which would survive longer in office. The lettuce of course won and the footage has since been acquired by the British Film Institute’s National Archive which feels about right. So when we look at the United Kingdom today, things are certainly a bit untidy. Gilt yields are near their highest level since 1998. Roughly 8 p in every pound that the British government collects goes towards debt interest alone before a single nurse is paid, a single pothole is filled, or a single commuter train arrives more or less on time. Prime Minister Keir Starmer’s Labour government suffered heavy losses in local elections earlier this month, which has done nothing to reassure the global asset managers who buy British debt. But compared to unburied dead and emergency IMF calls, what we’re watching today is an orderly, if expensive adjustment, the bond market is functioning as a sober referee, reminding the government that running large deficits for extended periods eventually requires an actual conversation about how to pay for them. Politicians, broadly speaking, prefer to have this conversation as late as possible or ideally never. Which brings us to the rather uncomfortable question of what happens when the people who are supposed to manage all of this have been operating under a 40-year illusion. In their new book, The Unanchored Central Banker, Pradhan and Goodhart suggest that central bankers have essentially spent the last few decades taking credit for a demographic accident. For roughly 40 years, a massive surge in the global working age population, combined with China’s emergence as the world’s factory floor, naturally kept wages and consumer prices incredibly low. Central bankers enthusiastically took credit for this, attributing the stable prices to their own brilliant policy frameworks, which is a bit like a surfer taking credit for the size of the waves. Now those demographics are reversing. Populations across the developed world are aging. The disinflationary tailwind that made central banking look straightforward for a generation is gone. And what’s replacing it is considerably less convenient. This is part of the backdrop against which Adam Posen, president of the Peterson Institute and Peter Orszag published a paper in January forecasting that US inflation could exceed 4% by the end of this year. Given that CPI is already at 3.8% in April, that forecast is looking less like a prediction and more like a weather report. They argued that a wide range of policy decisions, tariffs, fiscal expansion, supply chain fragmentation were all pushing in the same inflationary direction at once. Normally, when inflation drifts upward, the Federal Reserve raises interest rates to cool things down. The problem, as Posen has noted, is that the transmission mechanism, the process by which rate hikes actually slow the economy, is not working quite the way it used to. And here’s why. The technology companies driving the current investment boom have historically funded themselves from their own enormous cash reserves. But the scale of artificial intelligence infrastructure is now so vast that even they’ve been forced to borrow. And they’re doing it in a way that largely bypasses the traditional banking system. Hundreds of billions of dollars in new obligations are being moved off corporate balance sheets into special-purpose vehicles. Legal shells designed to keep the debt away from the headline numbers and funded through the private credit market. Morgan Stanley estimates that between 2025 and 2028, $800 billion of private credit capital will be required to finance AI data centers globally. Meta’s $30 billion deal for a single facility in Louisiana was the largest private credit transaction in history, and they’re expected to do more. The AI data center buildout has become one of the largest off-balance sheet financing exercises in corporate history. The private credit market that’s absorbing all of this has grown to well over a trillion dollars and almost all of it uses floating interest rates. Which means that if the Federal Reserve is forced to hold rates high to fight inflation, the interest costs on these AI projects automatically adjust upwards. The companies that borrowed to build the infrastructure that’s supposedly going to generate the future earnings to justify their current valuations could find themselves under significant financial pressure at exactly the moment that the broader economy is slowing down. Central bank independence is in this environment essentially the only structural defense between a managed adjustment and something considerably less orderly. The job of a modern Fed chair is to navigate all of this. Demographic headwinds, fiscal dominance, a broken transmission mechanism, and off-balance sheet leverage that doesn’t show up in the traditional data without either triggering a recession or letting inflation become entrenched. It is, not to put too fine a point on it, a difficult brief. Bill Gross, who spent 40 years as one of the largest buyers of US government debt on Earth and who is therefore at least worth hearing out on this topic, wrote in the FT recently that what we’re watching isn’t purely an inflation story. He pointed out that a 30-year Treasury inflation protected security currently yields 2.72% in real terms, which means inflation alone doesn’t fully account for where yields are today. Something else, he says, is doing some of the work. Gross calls it hegemonic decay. The idea that America is becoming a less unconditionally safe haven than it once was and that the dollar’s 10% decline on a trade weighted basis over the past 18 months is evidence of this. It is an interesting theory. The mild problem with it is that yields are rising more or less everywhere simultaneously. In Canada, Germany, Japan, the UK, and across most of the developed world. If this were purely a story about American hegemonic decline, you’d expect investors to be rotating out of US bonds and into something else. They’re mostly just uncomfortable buying long-dated bonds, which suggests that the problem is somewhat more universal than hegemonic decay implies. It is possible that the world’s reserve currency is losing its shine. It’s also possible that every major government has simply borrowed a great deal of money and investors would like to be compensated for that. Both things can be true simultaneously. Jamie Dimon noted this week that US debt stands at around $30 trillion at an average interest rate of 3.5%. Even today, he said they can’t possibly refinance it lower than that rate. He added that rates could go considerably higher. This is the sort of observation that sounds obvious when someone says it out loud, which is perhaps why it needed to be said out loud. Now, to be genuinely clear rather than falsely reassuring, the United States is not Britain in 1976. The dollar is still the world’s reserve currency. The Treasury market is still the deepest and most liquid on Earth. There’s no plausible alternative that global investors can rotate into at scale. The Euro area is too fragmented. Japan is dealing with its own yield problems and nobody is rushing to park their savings in Chinese government bonds. America has real structural advantages that give it considerably more room than any other borrower on Earth. What we’re probably watching is a long grinding repricing, not a collapse, but an adjustment. The era of essentially free government borrowing is over. The demographics that quietly made it easy for 40 years have reversed, and the politicians who would need to address the underlying position are broadly speaking hoping that the problem resolves itself. Central Bank independence, it turns out, is doing rather a lot of heavy lifting right now. Into all of this, on May 22nd, 6 days ago, Kevin Warsh was sworn in as the new chair of the Federal Reserve. He is a Harvard lawyer, a former Morgan Stanley banker, and served on the Fed’s board of governors during the 2008 financial crisis. He has, in other words, some experience of walking into a room that’s already on fire. At the swearing in ceremony, President Trump said, “I want Kevin to be totally independent.” No one was shoved against any walls, as far as we know. Paul Volcker fixed a version of this problem last time, but he had the considerable advantage of starting with a debt to GDP ratio of 30%. Warsh is starting at 101% with a war in Iran, tariffs on everything, a broken transmission mechanism, and a president who has described the Fed’s previous chairman as a total stiff, but I’m sure it’ll be fine. If you found this video interesting, you should watch my video on the SpaceX IPO filing next. Don’t forget to check out our sponsor, Incogni using the link in the video description. Talk to you again soon. Bye.