US government borrowing costs have been rising again. That sounds alarming. Higher bond yields are often interpreted as a warning that investors are losing confidence in America’s finances, its central bank or its ability to control inflation.
But look beneath the surface and a more encouraging explanation emerges: investors may simply be becoming more optimistic about US economic growth.
A government bond yield can be divided into three main parts: expected inflation, expected interest rates and an additional ‘term premium’ for lending money over a long period.
If investors were losing faith in the Federal Reserve, inflation expectations should be rising. They aren’t. Measures from the inflation swaps market remain consistent with inflation returning to the Fed’s 2% target.
If investors were becoming seriously worried about America’s debt, the term premium should also be rising sharply. Again, it isn’t. It has remained broadly stable.
That leaves expected interest rates. Investors now think the US economy may be able to sustain stronger growth, and therefore somewhat higher interest rates, over the long term.
That is an important distinction. Bond yields are not necessarily rising because markets fear a crisis. They may be rising because investors believe artificial intelligence, deregulation and more supportive tax policies could raise American productivity and economic growth.
Faster growth changes the debt equation. The US still has a serious deficit problem. But stronger growth would make it considerably more manageable.
A useful rule of thumb is that an additional percentage point of economic growth can reduce the annual deficit by roughly one percentage point of GDP. In a faster-growing economy, tax revenues rise, employment improves and government spending becomes easier to finance.
Inflation should also moderate if the recent energy shock caused by the Iran conflict subsides. Lower inflation would allow interest rates to fall, eventually reducing the enormous interest bill on US government debt.
None of this means America’s fiscal problems have disappeared. Reforming entitlement programmes and controlling wasteful spending remain major long-term challenges. Tariffs are also an economically contentious and uncertain source of revenue.
But the immediate picture may be less frightening than some headlines suggest.
What does this mean for investors?
First, higher bond yields are not automatically bad news. The reason yields are rising matters enormously. Rising yields caused by runaway inflation or collapsing confidence would be dangerous. Rising yields caused by stronger expected growth are much healthier.
Second, a stronger US economy should support corporate revenues and profits.
Finally, investors should watch inflation expectations and the term premium, not simply the headline ten-year Treasury yield. Those indicators currently suggest that markets retain confidence in both the Federal Reserve and the US government.
The key message is simple: the bond market does not appear to be signalling an American debt crisis. It appears to be pricing in a more resilient, productive and faster-growing US economy.
If that interpretation is right, rising yields are not a distress signal. They are a sign of economic strength.
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