Interest rates are rising globally. That spells trouble for stocks.

Mint

25-05-2025

In the parable of the blind men attempting to describe an elephant, one likens it to a snake after touching its trunk, while another describes it as a tree after feeling its leg. A third, touching its tusk, says it's like a spear. Given their limited perception, none can understand the entirety of the great animal.
So it is with much of the analysis of the rise in long-term interest rates—both the cause and implications. Most analysis focuses on a single aspect, notably the effects of the parlous fiscal situation of the U.S. But there are others, including the fiscal situation in Japan, with a debt burden twice that of America, that also should concern investors. That's because the rise in long-term interest rates globally threatens asset valuations, in particular stocks.
The headlines have centered on Moody's stripping the U.S. of its last triple-A credit rating. But based on the credit-default swaps market, where investors buy insurance against negative events, the costs to hedge U.S. government debt against default are consistent with ratings of Baa1/BBB+, near the lower end of investment-grade credits, according to Macquarie analysts Thierry Wizman and Gareth Berry.
As Doug Kass of Seabreeze Partners points out, U.S. CDS spreads are approaching those of Greece, with its barely investment-grade credit rating and history of defaults.
What's different is that the U.S. issues debt in its own currency, unlike Greece, which lashed itself to the euro. Japan, the government deepest in debt, also borrows in its own currency, the yen. That didn't stop its prime minister, Shigeru Ishiba, from saying his nation's financial condition was worse than Greece's, with debt equal to 2.5 times its gross domestic product.
It is no coincidence that Japan's fiscal problems are extending beyond its shores—just as the U.S. debt situation erupts in the bond market. Yields on long-term Japanese government bonds have surged recently, along with those of U.S. Treasuries, as the chart here shows. The two are related.
Japan has continuously run massive deficits, financed by the Bank of Japan buying up the bonds issued to cover the budget gaps. Japanese investors have bought JGBs at ultralow yields, as well. Even so, Japan had excess savings, which it invested in higher-yielding foreign securities, especially U.S. Treasury securities; that included both the Bank of Japan and the giant Japanese life insurers.
Now, things are reversing. Long-term JGB yields have soared to more than 3% from 2% in 2024 and about 1% in 2021. More to the point, that is more than a Japanese investor would earn in 30-year U.S. bonds, whose yields have ticked up over 5%, after deducting the cost of hedging for exchange-rate risks. So, the Japanese probably will repatriate funds that previously had pumped up other markets, especially the U.S., via the so-called yen-carry trade (borrowing at ultralow Japanese rates to buy higher-returning assets elsewhere, including Nasdaq stocks).
'If sharply higher JGB yields entice Japanese investors to return home, the unwinding of the carry trade could cause a loud sucking sound in U.S. financial assets," writes Société Générale global strategist Albert Edwards.
This could happen at a most inopportune time, after the passage of the Big Beautiful Bill, which would put the U.S. on a continued path of budget deficits in excess of 6% of gross domestic product, while the nation's overall debt would exceed the size of the U.S. economy. The burden of financing that debt at increasing interest rates is pushing up long-term U.S. bond yields, even after the Federal Reserve lowered its short-term rate target by a full percentage point last year.
President Donald Trump's favorite word—tariffs—will partially offset the impact of new tax cuts in the BBB, raising $1.5 trillion to $2.5 trillion over 10 years, based on the widely varying estimates of how much the import levies will bring in. The measure was passed by the House of Representatives and now heads to the Senate, where it could get slimmed down. Fiscally speaking, the dessert from the tax goodies may kick in before the vegetables from tariffs fully hit.
That may sound like good news for the economy, according to Paul Ashworth, chief North America economist at Capital Economics, but the budget deficit already is close to 6% of GDP while the economy is at full employment, and government debt is close to 100% of GDP and headed to nearly 120% in a decade's time.
BCA Research's chief geopolitical strategist, Matt Gertken, says Trump's fiscal doctrine to deal with this mess is 'Don't F___ With Medicaid." The better answer for the U.S. budget, both domestically and for the global economy, would be to cut spending and raise taxes. But that would be political suicide for Republicans.
Even the administration's historic spending cuts—some $1.6 trillion from the Department of Government Efficiency and things like the repeal of green-energy tax credits—will be swallowed up by the huge tax cuts, writes Gertken in a client note. The GOP already is courting voter backlash with cuts to Medicaid and the Supplemental Nutrition Assistance Program, which will hit many of their constituents in Red states. 'The saving grace for the U.S. is that its low-tax regime implies it can raise taxes in the future and improve its sustainability," he writes.
The bottom line is the Big Beautiful Bill is an 'abomination," writes Michael Darda, chief economist and strategist at MKM Partners, and an alum of Polyconomics, the advisory started by Jude Wanniski, the early supply-side-economics evangelist. 'New tax cuts in the bill are low bang-for-the-buck gimmicks that will not materially alter incentives for working, saving, or investment," he writes in a client note.
Better that the whole measure fail and let the Tax Cut and Jobs Act expire at the end of the year, which would mean a tax hike, he writes. 'This is the perfect time for austerity given, 1) the fiscal deficit is high and unsustainable, 2) the unemployment rate is low, and 3) the Fed's policy rate is over [4%.]"
Both Republicans and Democrats have promised economic programs that the current tax system can't support. The ability to borrow to pay for them is being constrained by rising bond yields, which further exacerbates the budget strains.
As the rates on supposedly risk-free government securities have climbed, the risk premia on investment-grade and high-yield corporate debt, and equities, have shrunk. The U.S. fiscal situation poses a 'ticking time bomb" for global markets, Soc Gen's Edwards concludes. That's the proverbial elephant in the room.
Write to Randall W. Forsyth at [e-mail]