In the third week of March 2020, as covid-19 spread panic through the world's markets, investors did something the textbooks said they would never do. Instead of rushing into American government bonds, the asset they flee to in every crisis, they sold them. Prices fell, yields jumped, and the deepest, most liquid market on earth began to seize. Only emergency buying by the Federal Reserve, more than $1trn of it within weeks, stopped the rot. The episode was brief and quickly forgotten. It should not have been, for it was the clearest sign yet that the foundation of global finance is less solid than almost everyone assumes.
Treasuries are far more than the means by which Washington borrows. For 80 years they have been the world's risk-free asset: the cushion banks hold against losses, the cash reserve of companies and foreign states, and the benchmark against which the price of almost every other loan, from corporate debt to American mortgages, is set. When the yield on Treasuries rises, the cost of borrowing rises everywhere, automatically and with no vote taken. A market this important is meant to be dull. Lately it has not been.
Two forces are pulling it out of shape. The first is on the demand side. For decades a class of price-insensitive buyers, above all foreign central banks parking their dollar earnings, bought Treasuries almost regardless of price. In 2008 official foreign institutions held about 38% of the market; today they hold around 13%. China is running smaller surpluses, others are spreading their savings more widely, and the freezing of Russia's reserves in 2022 reminded every government that a pile of dollars can be a liability as well as an asset. The small premium investors once paid for the unique safety of Treasuries, the "convenience yield", has all but gone. The dollar remains supreme; its bonds have quietly lost their privileged status.
The second force is supply, and it is the more alarming. America's debt is growing by roughly 8% a year. That would be unremarkable in a war or a slump, when heavy borrowing is both normal and wise. But America is at peace and near full employment, exactly the conditions under which deficits ought to be shrinking. Instead the annual shortfall runs above 6% of GDP, and the Congressional Budget Office expects it to keep climbing toward 6.7% by 2036. In 2026 federal debt held by the public passed the size of the entire economy for the first time since 1946. Back then the figure was already falling as a war wound down. Now it is rising in peacetime, with nothing in the forecasts to bend it back.
Put the two together and the danger is plain: an ever-larger pile of bonds must find buyers among an ever-more-reluctant crowd. Those who remain, hedge funds and asset managers, insist on a market price and walk away when they do not get it. The bond market has lost its shock absorber at the very moment it is being asked to bear more weight.
The plumbing makes matters worse. Trades still pass through a handful of big dealers whose capacity, hemmed in by capital rules written after 2008, has barely grown even as the market has roughly quadrupled. Much of the slack has been taken up by hedge funds running a heavily borrowed arbitrage, the "basis trade", financed overnight and exposed to the smallest tremor. When everyone sells at once, as in 2020, the dealers jam, the borrowing unwinds, and only the Fed can clear the blockage. That the central bank will always step in has become an unspoken assumption on which the whole structure rests. It is also the seed of the ugliest outcome of all: a central bank printing money to soak up the government's debt, with inflation doing the quiet work of default.
Optimists offer reassurance, and some of it is fair. America borrows in a currency it prints, so it can never be forced to miss a payment; the dollar's dominance is intact; and clever repairs are on the table. Regulators could loosen the rules so that dealers warehouse more bonds. Stablecoins, digital tokens backed by Treasuries, might summon up a few hundred billion dollars of fresh demand. Clearing houses and stiffer margins could tame the hedge funds. Each idea is sensible. None of them reaches the problem. Every one reinforces the market through which the bonds flow; not one slows the flow itself, which swells by some $2trn a year.
That is the uncomfortable truth at the centre of all this. The fragility is fiscal, not technical, and so is the cure. As Nellie Liang, until recently America's under-secretary for domestic finance, has said, regulators cannot fix the whole problem: the fiscal position needs to be sustainable. Closing a gap of a few percent of GDP, through some blend of higher taxes and lower spending, is not economically hard, and plenty of countries have done it. It is politically wretched, because the pain of acting lands at once while the pain of drift is deferred and spread thin. So Congress defers, as it has for years, soothed by an old article of faith, voiced by a Republican vice-president in 2002, that "deficits don't matter". For 40 years growth outran the interest bill and made that look like wisdom. It no longer does.
Markets, when their patience finally snaps, move fast: Britain's bond rout in 2022 toppled a prime minister in barely seven weeks. America is bigger and cannot be pushed around so easily, but it is not exempt from arithmetic. For three generations the world has lent it money cheaply, on trust. The price of that trust is now being marked up in plain sight. The wise course is to act before the lenders insist on it. The foolish one is to assume, as Washington seems to, that the safest market in the world will stay safe simply because it always has.