Investors Are Sending a Warning to Congress. Will Washington Listen?
As Republicans haggled this week over a tax bill that would add trillions to federal deficits, the long-term cost of financing the national debt surged.
That wasn't a coincidence — it was a warning.
And it was as gently as the bond market is going to warn the U.S. that the path of the national debt is a problem.
In conversations with investors this week, I heard a new level of focus on the sheer volume of debt that Washington is set to pump out and, in some cases, real concern about how it will play out in markets. It was a shift from the perennial elite conversation, where the consensus has generally been that the debt is a worry, but not an immediate one.
'For the first time in my professional life, we're seeing a shift, with investors looking askance at Treasury debt,' said John Velis, Americas macro strategist at BNY Mellon, a bank responsible for safekeeping $53 trillion in assets.
Congress is not known for heeding gentle warnings.
The proximate cause of the market response, beyond the congressional debate itself, was a downgrade by credit ratings firm Moody's of the U.S. government's status as a borrower — a move they warned was possible back in 2023.
It's not that the Moody's decision told bond investors something they didn't already know. But 'the downgrade focused minds,' Velis said.
Investors are absorbing the details about how much new debt the U.S. is going to be issuing — as well as considering the high volume of debt that's going to come from other governments across the world — and they're saying they need a more attractive return to lend to the U.S. Treasury.
That means a larger proportion of tax dollars will be swallowed by interest payments on federal debt rather than something more productive. Yields on 20-year and 30-year government bonds closed out Wednesday and Thursday above 5 percent.
That's high, but not frightening — yet.
Still, if lawmakers don't react to more benign signals, they likely won't act until something more painful happens — a more pronounced jump in yields, a default, a failed auction of U.S. debt, etc. When will that happen? Who knows? It could be months, or it could be decades.
But there might not be a big warning beforehand.
A lot of investors lose money when Congress abruptly changes course after a sell-off; nobody wants to sell low and then buy high. That leads to a weird game theory calculation that can have the effect of restraining a disapproving market reaction: If traders think lawmakers will respond to their negative reaction by reversing the policy, they might hold off — until there's a horrifying plunge.
Josh Frost, who oversaw debt management under President Joe Biden as assistant Treasury secretary for financial markets, called it an 'unstable equilibrium.'
'Markets have generally been burned by policy U-turns,' Frost told me, adding: 'It's awfully hard to sell out of a position only to buy it back a day later.'
At least a few important lawmakers in Washington are already watching this dynamic closely. Before the run-up in yields this week, House Budget Chair Jodey Arrington (R-Texas) told me the bond market would be the ultimate arbiter of what is an acceptable tax-and-spend package.
'If the bond markets don't think we're serious,' he said, 'I'm not sure it will matter what we do, because they're going to dictate the terms.'
So far, it's unclear whether the market reaction this week will be enough to actually shift the trajectory of the 'big, beautiful bill.'
The legislation has cleared the House but now faces the Senate GOP gauntlet, where Sen. Ron Johnson (R-Wis.) has called for steep cuts to return the U.S. to pre-pandemic levels of spending.
The hard-fought compromise among Republicans in the House was delicate enough that any changes could snarl the bill. Johnson told me at a recent POLITICO event that the initial response to his hawkish push was dismissive — Johnson summed it up as: 'That ship has sailed' — though he now says there are enough votes to block the bill absent more spending reductions.
Still, when in doubt, Congress typically chooses to tax less and spend more.
There are good reasons to stay calm about all this. Financial institutions hold U.S. government debt for all sorts of reasons, many of which are unlikely to change. The angst in the market this week is far from universally shared.
'There's a certain inertia behind the behavior of bond markets, in which 65 to 70 percent of holders can't really sell all that materially,' said Guy LeBas, chief fixed income strategist at Janney Capital Management. 'We can sit here and gnash our teeth about fiscal unsustainability, but none of us are doing anything about it.'
To put markets at ease, Washington would not need to start balancing the budget. Despite political rhetoric suggesting otherwise, the government's finances are not like a household's — unless your family happens to issue its own currency and that currency is treated as a global reserve asset.
Much of world trade is conducted in dollars, and companies and foreign governments have savings in the U.S. currency, so it is convenient for them to also own U.S. debt. Because demand for the dollar is strong, the U.S. federal government can run higher deficits than other countries.
The problem, economists say, is that the debt is growing faster than the economy, driven by mandatory spending programs like Social Security and Medicare. To put this in context, all of discretionary spending — the stuff Congress fights about in funding bills — was $1.8 trillion in fiscal year 2024. The size of the deficit? $1.8 trillion.
Treasury Secretary Scott Bessent has said he would like to see a deficit-to-GDP ratio of 3 percent, down from its current rate above 6 percent, which is quite high by global standards.
Lazard CEO Peter Orszag, who previously led the Congressional Budget Office and the Office of Management and Budget, channeled the new mood of debt-focused dismay at the Milken Institute's Global Conference earlier this month.
Previously, Orszag said, he had tended to filter out 'all the Chicken Little, kind of, 'the sky is falling' fiscal stuff, because all of the dire predictions were not happening.'
'But if you compare where we are now to where we were a decade ago, it's a lot different. The deficit is twice as high. Interest rates are dramatically higher,' Orszag argued, adding: 'I think it's time to worry again about this trajectory.'
Few leaders in Washington are acting like they share that view.
Let's be clear: The debate about fiscal responsibility in Washington this week was about how much worse to make the situation, not how to make it better. By extending trillions of dollars in tax cuts, and adding on some more that are politically popular without also making politically painful spending cuts, Congress is starving itself of revenue that could help pay for the programs it continues to authorize.
In other words, they're giving us all back money they still want to spend.
And bond investors know this.
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