Affordability? Trump's foreign policy is driving up interest rates

Over the last month, he has engaged in two controversial and rare interventions in financial markets.

The first came in early August when the U.S. Treasury joined the government of Japan in its efforts to strengthen the yen by buying the Japanese currency, taking a step it had last taken during the Asian Financial Crisis in 1998. And late last week, Bessent announced that the Treasury could double the amount of long-dated Treasuries that it will buy back from current holders.

The theme that unites both interventions is a concern that the interest rates the U.S government is paying on its long-term debt (also known as bond yields) are rising too high and too fast, with 30-year U.S. Treasury bond yields reaching 5.3%, levels last seen in 2007.

Last February, Bessent said the administration was focused on lowering bond yields. The reason is simple: the interest rate the U.S. government pays on its long-term debt feeds into every other part of the economy, including how much businesses pay to borrow; the monthly cost of a new mortgage; how fast the government’s debt burden grows; and how the stock market might perform. But this crucial metric appears to have escaped containment.

The rise in interest rates is a global phenomenon . Market professionals have long noted that bond yields across the world’s developed economies tend to move together. Indeed, that is likely one of the reasons that the Treasury took the very rare step of helping Japan in its intervention efforts. It worried that a vicious circle connecting a weakening yen, worries about higher Japanese inflation, and higher Japanese bond yields could feed back into U.S. bond markets as well.

These worrying trends are in no small part a result of the Trump administration’s approach to foreign policy. By driving up defense spending, imposing waves of tariffs, and launching a war that has closed the Strait of Hormuz, President Donald Trump is placing enormous pressure on markets that Bessent is now trying to tame.

Of course, some key drivers of this bond yield trend are at best tangentially related to Trump’s foreign-policy shifts. One is the sheer size of debt and deficits across the world. U.S. government debt crossed the $40 trillion mark , and the Congressional Budget Office estimates a $2.1 trillion fiscal deficit this year or about 6% of U.S. GDP, a level unprecedented outside recessions. Even more striking is that the U.S. Federal government interest payments on its stock of debt have hit a percentage of GDP last seen in 1990.

Another factor often mentioned by market professionals is concern about the credibility of the Federal Reserve (Fed) and its commitment to fighting inflation. The new chair of the Fed, Kevin Warsh, entered the position with a reputation as a hawk (i.e., central bankers whose concerns about inflation make them more likely to raise interest rates), but U.S. interest rates were left on hold at his first outing, even as the decision was accompanied by three dissenting votes that wanted to see higher interest rates.

This has come alongside persistent White House criticism of the central bank and a seeming revival of the effort to oust Governor Lisa Cook in the face of a Supreme Court decision favoring her stay. All this has sparked worries that the administration wishes to engineer a more compliant Fed through appointments. Insofar as investors see central bank independence from political interference as an essential tool to hold inflation in check (an opinion backed by academic research) , it would not be surprising if they react to perceived threats to such independence by demanding higher interest rates as compensation for higher risks.

But beyond all these factors linked to the U.S. fiscal outlook and interactions between America’s monetary and fiscal authorities, there is another factor that has pushed inflation higher both in the U.S. and in much of the world: a series of shocks to the global supply of goods and commodities. And while these shocks began in 2020 with Covid-19 and accelerated with Russia’s invasion of Ukraine in 2022, they have since been amplified by foreign policy shifts in Washington that have heated up trade wars and started a hot war.

Soon after taking office last year, the administration embarked on two signature measures — broad-based increases in tariffs, and an insistence that other countries spend a larger portion of their GDP on defense. The latest estimates from Yale Budget Lab estimate that tariffs increase consumer prices by 0.7%. This might not seem like a lot, but when considered against a 2.0% target for inflation that will almost certainly be missed for the sixth straight year, tariff-driven inflation represents another important factor that has pushed up bond yields, threatening the broader economy through the channels described above.

It is worth noting that one of the administration’s justifications for tariffs has been that they add to government revenues. However, tariffs may also be increasing government costs to some degree, and not just through the widely noted compensation to groups suffering tariff retaliation, like the $12 billion has been set aside for farmers. Interest payments are also a cost to the Treasury, and with a debt stock of $40 trillion, an increase of even 0.1% in interest rates on U.S. government liabilities adds $40 billion to the bill.

Beyond this, U.S. actions last year had two other impacts on the quantity of global savings available to invest in America. Forcing allied countries to spend more on defense most likely means that they have less to lend the U.S. This might not be an issue if the U.S. concurrently reduced its defense expenditures to the same degree, but that is not the case. President Donald Trump asked for a $1.5 trillion military budget, even as he insisted that other countries “ pull their weight. ”

It also appears that foreign sovereign governments have become less important as lenders to the U.S. (perhaps reflecting a combination of their own spending needs and political misgivings about certain aspects of U.S. policy). This has meant that price-sensitive private investors are playing a larger role, and these investors want to be protected from inflation by receiving higher interest payments, pushing up bond yields.

The Iran war has made things even worse for the bond market on three separate fronts: it has increased U.S. defense spending further; led to substantial physical damages and massive reconstruction needs in the Persian Gulf (reducing those states’ ability to invest in U.S. bonds and raised global inflation risks to an even greater degree.

For example, while crude oil prices have retreated substantially from the highs reached in the early days of the war, diesel prices are near the highs of the decade , reflecting physical damage to refineries in two war zones – the Persian Gulf and in Russia. These costs are in turn likely to feed into trucking and agriculture, with downstream effects on those prices.

This might seem to be an especially difficult situation for the Global South, but thus far at least, the response of financial markets has differentiated among them on the basis of region, economic endowments, and vulnerability. As in 2022 at the outbreak of the Russia-Ukraine War, some Latin American currencies have been helped by distance from the conflict and the status of Brazil and Colombia as exporters of fossil fuel, while Mexico has been rewarded for a relatively untroubled trading relationship with the U.S. thus far (certainly compared to the U.S.-Canada relationship ).

Conversely, things have been more difficult in South and Southeast Asia, an oil-importing region that secures the bulk of its energy from the Persian Gulf, where India and Indonesia have both been hit hard, with India also suffering from growing concern that its service export model could be hit hard by the AI revolution.

Looking ahead, a swift end to the war and a resumption of global energy flows seems essential to assuage worries about inflation and government fiscal trajectories around the world, including the U.S.