On Wednesday, the world was given a reason to celebrate. US inflation had eased to 3.4%, down from 3.5% in June. Core inflation, excluding food and energy, fell to 2.5%.1 The next day, producer prices were even more encouraging as the Producer Price Index was unchanged in July.2

For financial markets, this should have been straightforward. Lower inflation means the Federal Reserve has less reason to keep interest rates high. Lower expected interest rates mean cheaper borrowing, higher equity valuations and, usually, lower government bond yields.

Yet, something stranger is happening. The Federal Reserve’s policy rate sits at 3.50–3.75%.3 Yet the yield on a 10-year US Treasury remains around 4.6–4.7%, while the 30-year yield is above 5%.4 The Fed controls the overnight interest rate. It does not directly control what investors demand to lend to the US government for the next ten or thirty years.

Additionally, those investors find themselves worrying about America's fiscal position as well. This results in an uncomfortable possibility. Monetary policy may be moving in one direction while the bond market moves in another.

The interest rate the Fed doesn’t control

To understand why, consider what a 10-year Treasury yield actually represents. An investor buying a 10-year government bond is essentially saying, "I will lend the US government money today, provided I am compensated for waiting ten years to get it back." That compensation depends on several things - expected inflation, expected short-term interest rates, the perceived risk of holding the bond and, crucially, the amount of government debt that needs to be absorbed by investors. This is why the 10-year yield can remain high even when markets expect the Fed to cut rates.

If investors expect short-term interest rates to fall, the yield on a 10-year bond should normally fall too. But if investors simultaneously expect inflation to remain volatile, government borrowing to rise, or the supply of bonds to overwhelm demand, they can demand a higher return for holding long-term debt. In other words, the Fed controls the price of money today. The bond market prices the cost of money tomorrow.

And this week, the distinction has become increasingly visible.

The 10-year Treasury yield eased only to around 4.68% on August 13, despite two consecutive softer inflation readings.5 It is not an enormous move in isolation. But the persistence of elevated long-term yields is much more interesting than any single daily movement.

Because it suggests markets are beginning to price something beyond monetary policy.

The deficit hiding behind the yield

That something is fiscal policy.

The US government recorded a $432 billion budget deficit in July alone, the largest July deficit on record.6 Government spending reached roughly $766 billion against $334 billion of revenue. Interest payments on the national debt alone were around $117.5 billion during the month.7 However, part of that figure reflects timing. This is due to the fact that the 1st of August fell on a non-working day, meaning military, veterans and Medicare payments due for the start of August were included in July's figures. Adjusting for these effects, the fiscal year is running around 5% wider than 2025 rather than the 48% jump the monthly headline implies. Despite this, the direction is correct, but the single month overstates it.

The problem is not simply that the government is borrowing more but rather that its borrowing creates more bonds. The Treasury finances deficits by issuing government securities. When the government needs to borrow heavily, the supply of bonds entering financial markets increases. If demand does not increase at the same pace, bond prices fall.

Because bond prices and yields move inversely, falling prices mean higher yields.

This creates a strange feedback loop. Higher government deficits mean the Treasury has to issue more debt. This increases the supply of government bonds in financial markets, which can push bond prices down and yields up. As yields rise, the government faces higher interest costs on both new and refinanced debt, potentially widening the deficit even further.

It is not an automatic debt spiral. The US has enormous financial resources, a deep capital market and the world’s dominant reserve currency. But the mechanism does make a tangilbe difference. At some point, investors may start asking not whether the US can repay its debt, but what return they require for holding so much of it.

Why this matters for the rest of the economy

The 10-year Treasury is not just another financial asset. It is effectively the benchmark interest rate for much of the global financial system. Mortgage rates, corporate borrowing costs, infrastructure financing and the valuation of financial assets are all influenced by longer-term government bond yields.

Imagine the September hike the markets have priced in does not arrive. Normally, this should loosen financial conditions. But the 10-year Treasury yield has barely moved on two rounds of softer data, because investors are demanding a higher term premium to compensate for fiscal and inflation risks.

This means that the economy does not receive the full benefit of the rate cut. A mortgage lender does not necessarily care that the overnight Fed funds rate has fallen if its own long-term funding costs remain elevated. A company deciding whether to build a new factory looks at the cost of financing over many years, not the overnight rate. A pension fund deciding between equities and bonds looks at the return available across the entire yield curve. This is why long-term yields can matter more to the real economy than the headline Fed rate and thus the transmission mechanism of monetary policy can begin to weaken.

Across the world

The story becomes even more interesting when we leave America. For decades, Japan has been one of the world's cheapest sources of financing. Japanese interest rates remained exceptionally low while US rates were considerably higher. This encouraged investors to borrow cheaply in yen and invest the proceeds in higher-yielding assets elsewhere.

This strategy is known as the yen carry trade.

If borrowing in Japan costs 1% while a US Treasury or another asset offers 4–5%, the difference can be attractive. But the strategy contains a hidden risk: exchange rates.

If the yen suddenly strengthens, the cost of repaying those yen-denominated loans rises relative to the value of the foreign assets. That is precisely why Japan's currency has become a global financial issue.

On 31 July, the US and Japan intervened jointly to support the yen, in a rare coordinated operation whose size neither side has disclosed.8 The move temporarily strengthened the currency, but the underlying interest-rate gap between the US and Japan remains significant.

Japan is the world's largest foreign holder of US Treasuries. If Japanese investors become more attracted to domestic assets as Japanese yields rise, the marginal demand for US government debt could weaken.The US therefore has an unusual dependence on global capital flows, its government can issue the bonds, but it cannot force foreign investors to want them.

The paradox of “good” inflation news

The immediate market reaction to inflation this week was positive. Lower inflation reduced expectations of another Fed rate hike, while US equities moved higher. The S&P 500 reached an intraday record on Thursday, while Treasury yields fell.9

But beneath the optimism lies a more complicated picture. Headline CPI is still 3.4% — well above the Fed's 2% target. Energy prices have risen sharply over the past year, and producer prices remain 4.7% higher than a year ago.10 Meanwhile, the government continues to borrow on an enormous scale.

So markets are balancing two competing forces. Monetary disinflation is pushing yields down while, fiscal expansion and debt issuance are pushing them up. This explains why the bond market can look surprisingly pessimistic even when the stock market is celebrating softer inflation.

The two markets are not necessarily disagreeing. They may simply be looking at different time horizons. The bigger macroeconomic problem is the relationship between finance and macroeconomics. For much of the post-financial-crisis era, it was easy to think about interest rates as something controlled almost entirely by central banks. The Fed raised rates; borrowing became more expensive. The Fed cut rates; borrowing became cheaper.

But government debt has become so large, and financial markets so globally interconnected, that fiscal policy increasingly constrains monetary policy.

It is not quite a return to the 1970s, nor does it mean a US debt crisis is imminent. The dollar remains the world's dominant reserve currency, and US Treasuries remain among the world's most liquid and widely held assets.

Therefore, the risk is not necessarily a crash. The most interesting question is therefore not whether the US government will default. It almost certainly won't. The question is whether the US can continue borrowing at increasingly high interest rates without those rates themselves becoming a macroeconomic constraint.

Every percentage point increase in the cost of refinancing government debt eventually feeds into the budget, which means less fiscal space for future governments. It can mean higher taxes, lower spending or simply more borrowing.

And if investors begin to believe that persistent fiscal deficits will eventually generate inflation, they may demand even higher nominal yields to compensate. It may be the fact that, despite encouraging inflation data, the world's largest bond market is still demanding a relatively high price for lending to the world's largest government.

Footnotes

  1. US Bureau of Labor Statistics, Consumer Price Index Summary — July 2026 (opens in a new tab), 12th August 2026.

  2. US Bureau of Labor Statistics, Producer Price Indexes — July 2026 (opens in a new tab), 13th August 2026.

  3. Federal Reserve, Federal Reserve issues FOMC statement (opens in a new tab), 29th July 2026.

  4. CNBC, Fed meeting recap: Warsh says Fed won’t hesitate to stop inflation, but bond market has doubts (opens in a new tab), 30th July 2026Trading Economics, United States Government Bond 10Y (opens in a new tab), 13th August 2026.

  5. CNBC, Goldman says Japan's $1 trillion of reserves leaves 'plenty of capacity' for further yen interventions (opens in a new tab), 13th August 2026.

  6. US Department of the Treasury, Monthly Treasury Statement of Receipts and Outlays of the United States Government, for Fiscal Year 2026 Through July 31, 2026 (opens in a new tab), 12th August 2026Transport Topics, US Posts Record July Budget Deficit of $432 Billion (opens in a new tab), 13th August 2026.

  7. US Department of the Treasury, Monthly Treasury Statement of Receipts and Outlays of the United States Government, for Fiscal Year 2026 Through July 31, 2026 (opens in a new tab), 12th August 2026.

  8. Al Jazeera, Japan and US confirm rare joint intervention to prop up yen (opens in a new tab), 3rd August 2026.

  9. TheStreet, S&P 500 sets new record, clearing 7,800 for the first time (opens in a new tab), 13th August 2026Trading Economics, United States Government Bond 10Y (opens in a new tab), 13th August 2026.

  10. US Bureau of Labor Statistics, Consumer Price Index Summary — July 2026 (opens in a new tab), 12th August 2026US Bureau of Labor Statistics, Producer Price Indexes — July 2026 (opens in a new tab), 13th August 2026.