Global Public Debt: Why Governments Have Less Room for Error

Earlier this month (October 2026), the International Monetary Fund (IMF) published its yearly report, World Economic Outlook. It included a very interesting set of graphs relating to government finances:

Across the world, governments are facing a challenging fiscal environment. Global public debt remains near historic highs following major economic disruptions such as the COVID-19 pandemic. At the same time, higher interest rates, ongoing budget deficits, and a heavy reliance on short-term borrowing are making it substantially more expensive for nations to manage their debt.

The takeaway from recent IMF data is clear: While strong economic growth can help stabilize debt burdens over time, the combination of elevated debt levels and higher refinancing costs leaves governments with less room for error than in the previous decade.

Key Takeaways Explained Simply: Four Pressures

1. Debt Remains Near Record Highs

Historically, global public debt has surged after major crises and has tended to subside following periods of economic stabilization. Today, global public debt as a share of GDP sits around 100%, far higher than before the COVID pandemic.

2. Annual Deficits Are Still Wide

A government runs a “primary deficit” when its regular spending (excluding interest payments) exceeds its revenue from taxes. In most major economies, including the U.S., China, France, and the U.K., primary deficits from 2020 through 2025 have stayed wider than their pre-pendemic averages. Current government plans do not appear sufficient to reduce spending or increase revenues enough to prevent debt ratios from rising further.

3. Borrowing Costs Have Risen

During the 2010s, record-low interest rates made it cheap for governments to borrow. Over the past three years, real (inflation-adjusted) interest rates have risen substantially in the US, the UK, Europe, and Japan. This directly increases the interest expense taxpayers and governments must cover.

4. The Rollover Risk: Short-Term Debt Meets Higher Rates

A substantial portion of government debt has relatively short maturities. When these obligations mature, governments often refinance them by issuing new debt rather than repaying them outright. We call this process refinancing risk (also known as a rollover risk). Because these new bonds carry higher interest rates, debt servicing costs will continue to rise over the coming years. 

Why This Matters

When a government spends an increasing share of its budget on interest payments, it creates two major challenges:

• Crowding Out Priorities: Fewer resources remain available for public investments, healthcare, infrastructure, education, and national defence.
• Eroded Buffers (“Fiscal Space”): In a healthy economy, governments keep debt manageable so they can step in with support during emergencies (e.g., recessions, health crises, or geopolitical events). With debt already stretched thin, the room to maneuver during the next downturn is significantly constrained.

Conclusion

The IMF data highlights a fragile equilibrium. Managing elevated debt levels while refinancing obligations at higher rates will require careful fiscal discipline. I remain highly skeptical that government officials will succeed. While it is impossible to predict the catalyst of the next financial crisis, elevated sovereign debt levels and shrinking fiscal space appear to be important vulnerabilities that deserve close attention. I may be overly concerned, but the data certainly reinforces that view.      

AI's Next Big Question: Will Future Cash Flows Justify Today's Investment Boom?

According to the Financial Times reporting,

"More than $9bn worth of CDS linked to bonds issued by Oracle, SpaceX, Alpha­bet, Amazon, Meta, Broad­com and Nvidia was traded on average each week in September, up from less than $2bn in July, accord­ing to Morgan Stanley Research. US cor­por­ate CDS index trading volumes this year have overtaken last year’s total, according to Bloomberg.

AI-linked debt issuance has rocketed with companies raising an estimated $466bn so far this year, up from $101bn in the same period in 2025, according to Morgan Stanley, to fund infrastructure such as data centres and chips.

Five-year Meta CDS has this month climbed to 108 basis points, meaning it costs $108,000 a year to insure $10mn of debt against default, while derivatives tied to Nvidia have climbed to 101bp. Protection against Alphabet and Amazon default is also at record highs.

Oracle’s CDS is now 322bp, up from 144bp at the start of the year. The five-year CDS tied to CoreWeave debt is trading at about 1,090bp, with demand so high that a buyer of $10mn of pro­tection would need to pay $1.82mn upfront."

My Take:

This is an interesting piece of information because it suggests that the broader market is becoming more aware of potential credit risks associated with the massive AI investment cycle. While increased CDS activity does not necessarily imply that defaults are imminent, it is an important data point because many financial crises have historically begun with credit events that later cascaded through the broader financial system.

Make no mistake, AI is here to stay. That is not the question. The FT article signals to me that investors are beginning to ask a question that has surfaced during many investment booms: Will the future cash flows generated by these enormous investments ultimately justify the amount of debt and capital being committed today?

Demystifying GDP: What 10 Years of Data Reveal About Spending, Investment, and Global Capital Flows

When news outlets report on economic health, GDP is almost always the start of the show. We often hear that it grew by 2% (we are richer) or that it shrank by 1% (we are poorer), treating it like a single national scorecard. Yet, beneath that single headline number lies a simple but helpful formula that helps explain how an economy functions, who is investing, and how a nation interacts with the rest of the world.

By looking at the GDP equation alongside a decade of data from the FRED database from 2016 to 2026, we can uncover an interesting story about modern economic life, including why a “negative” trade balance isn’t simply a loss, but a reflection of global capital flowing across borders.

The Anatomy of an Economy: The GDP Equation

At its core, GDP measures the total market value of all finished goods and services produced within a country over a specified time period. Economists commonly track GDP using the so-called expenditure approach, which breaks economic activity into four distinct buckets:

GDP = C + I + G + (X – M) 

Here is what each component represents:

• Consumer Spending (C): Everything households purchase.
• Business Investment (I): Capital to build future productive capacity.
• Government Spending (G): Spending by local, state, and federal government (excludes social service spending).
• Net Exports (X – M): What we sell to other nations minus what we purchase from abroad.

A Decade in Numbers: What the Data Shows (2016 – 2026)

Let’s examine the historical time series of the U.S. Real GDP (adjusted for inflation, measured in chained 2027 dollars) between 2016 and 2026:

Here is another view of the data:

Key Observations:

• The Consumer Remains the Engine: Consumer spending consistently makes up about 70% of total GDP.
• Investment and Government Share the Remaining Domestic Slice: These categories together account for approximately 35% of GDP.
• Net Exports Have Consistently Run Negatives: The Net Exports category has remained below zero across the entire 10-year span. The trade deficit expanded from approximately 3% of GDP in 2016 to 5% in 2026.

Demystifying the Minus Sign: Are Imports a “Drag” on GDP?

A persistent misconception in popular commentary is that because imports are subtracted from the Net Exports formula (X = M), running a trade deficit reduces or destroys economic growth. Let me give a simple example to show why that is not the case.

When an individual buys a $1,500 imported television, the full $1,500 is immediately added to Consumer Spending (‘C’). However, that television was produced abroad, not domestically. Because GDP only measures domestic production, the accounting system subtracts $1,500 under Imports (‘M’). Therefore, the calculation balances out: +$1,500 in C + -$1,500 in M = 0 (net change to GDP).

Subtracting imports is simply an arithmetic correction to ensure foreign-made goods counted in side C, I, and G are not falsely credited to domestic factories.

The Real Meaning of Negative Net Exports: Borrowing from the World

When an entire country buys more goods and services that it produces, it must finance the difference through capital inflows from abroad. This brings us to one of the most fundamental relationships in macroeconomics: the Saving-Investment Identity:

National Saving – Domestic Investment = Net Exports

When Net Exports are negative (a trade deficit), it directly implies that Domestic Investment > National Savings. This means that the country does not have enough domestic savings to fund all private investment and government borrowing; as a result, it must obtain capital from abroad. Foreign exporters who earn dollars selling goods do not simply stash those dollars away. Instead, they reinvest them back into the domestic economy (e.g. purchasing government and corporate debt, or acquiring productive assets).

Viewing trade through the lens of capital flows gives us a far more balanced perspective. Accessing global capital flows allows the U.S. to invest in capital at higher levels than domestic savings alone would support. However, persistent capital inflows (trade deficits) increase foreign claims on future domestic income, whether through interest payments on debt or dividends and asset returns sent to foreign owners.

Having said that, it is worth pointing out that whether a trade deficit is beneficial or harmful depends largely on how the associated foreign capital is used. Capital that finances productive investment can enhance future growth, while capital that primarily supports consumption or persistent fiscal deficits may create long-term vulnerabilities.

Furthermore, while the saving-investment identity shows that trade deficits are associated with domestic investment exceeding national saving, economists debate the direction of causation. Some emphasize insufficient savings, others point to attractive investment opportunities that draw foreign capital, and others focus on monetary conditions that encourage borrowing and spending.

Conclusion:

The GDP formula is more than an abstract equation; it is a live mirror of national economic choices. The past decade of data illustrates an economy anchored by high consumer spending and supported by investment levels that exceed domestic savings, something which has been made possible by a global financial system that continues to supply the necessary capital. A key systemic risk is the disorderly reduction in capital inflows without a concomitant increase in savings, which could lead to a severe economic contraction. This is no speculation. It is a possibility and something we should be mindful of.

Upstream Pressure, Downstream Reality: What the CPI vs. PPI Gap Means for Corporate Profits and the Economy

This past week we read about the headline Consumer Price Index (CPI) and how it compares to the Median CPI (read my post here). Here in this note, I will explain what the CPI says with respect to the Producers Price Index (PPI). The PPI tracks the wholesale selling prices received by domestic businesses.

Comparing the CPI and PPI provides a view into corporate profit margins, business pricing power, and the inflation pipeline. The latest economic data reveals a significant divergence: wholesale costs are rising much faster than retail prices (PPI at 6.3% vs. CPI at 3.7%). This gap points to an upstream supply shock that is currently squeezing corporate profit margins rather than fueling an economy-wide boom.

The Mechanics: What the CPI vs. PPI Relationship Tells Us

To understand how inflation moves through the economy, economists monitor the “spread” between what consumers pay and what producers receive as a rough proxy for the pressure on corporate margins:

Profit Margin Proxy Spread = CPI – PPI

When the CPI is greater than the PPI (Positive Spread):

• Consumer prices rise faster than wholesale input costs.
• Businesses have high pricing power and can easily pass on costs.
• Result: Corporate profit margins expand.

When the PPI is greater than the CPI (Negative Spread):

• Wholesale input costs rise faster than consumer prices.
• Businesses face resistance when attempting to pass higher costs on to consumers.
• Result: Corporate profit margins are squeezed.

While the CPI-PPI spread can provide insight into pricing power and margin pressure, it should not be viewed as a direct measure of corporate profitability. Labor costs, financing costs, productivity trends, and industry-specific factors also influence profit margins.

In addition to serving as a profit margin proxy, the PPI acts as an early-stage inflation pipeline: changes in wholesale costs often influence consumer prices with a lag, although the timing and magnitude vary considerably (some believe it often takes 3 to 6 months for them to filter into consumer prices). Although the CPI and PPI do not measure the same basket of products, the important observation is that they are directionally related.

What the Latest BLS PPI Report Shows

The latest release from the U.S. Bureau of Labor Statistics highlights a dramatic surge in upstream costs:

• Annual Surge: Over the last 12 months, the PPI for final demand jumped 6.3%, the fastest 12-month advance since December 2022.
• Monthly Acceleration: In September alone, the final demand prices increased 1.3%, the fastest 12-month advance since March 2022.
• The Energy Driver: Over 80% of the goods increase was driven by energy costs, which jumped 10.8% in a single month (led by a 20.3% spike in gasoline).
• Underlying Core Wholesale: Even after stripping out food, energy, and trade, core PPI rose 5% over the last year, indicating that wholesale cost pressures are broad across the industrial supply chain.

Interpreting the CPI vs. PPI Spread Chart

Courtesy of ZeroHedge, we obtained the following graph:

Let’s analyze the big picture of where we are in the economic cycle. When the CPI is greater than the PPI, you see a positive spread (green bars). When the PPI is greater than the CPI, you see a negative spread (red bars).

• 2015 – 2016: Strong corporate profit margin expansion (green bars, CPI > PPI)
• 2021 – 2022: Massive supply shock / corporate profit margin squeeze (deep red bars, CPI < PPI)
• 2023 – 2024: Corporate profit margin recovery (green bars, CPI > PPI)
• 2025 – Present: Sharp negative plunge to -2.6% (red bars, CPI < PPI)

Key Takeaway: The current deep red bars demonstrate that this is a classic supply/cost shock. Businesses are currently absorbing a substantial portion of higher wholesale energy and logistics costs rather than passing 100% of them immediately onto consumer price tags.

Conclusion

Federal Reserve monetary policy has a delicate balancing act to perform, because it cannot pump more oil or clear transport bottlenecks. Aggressive interest rate hikes to curb inflation could have the knock-on effect of choking off business investment and hiring, which will heighten recession risks. The risk is a type of self-fulfilling prophecy: in attempting to prevent inflation from becoming entrenched, the Federal Reserve may tighten financial conditions enough to contribute to the very recession it hopes to avoid. My view is that the Federal Reserve is likely to continue following its stated guidance and respond to persistent inflation pressures with additional gradual interest rate hikes.

If wholesale costs remain near 6.3% for multiple quarters, businesses will be tempted to eventually pass these higher costs through to consumers to protect corporate profit margins, which could push the CPI higher in 2027. 

Why an October Rate Hike Appears Increasingly Unlikely

According to the Financial Times reporting,

“Federal Reserve chair Kevin Warsh has signalled that hotter-than-anticipated inflation has not swayed his views on the US economy, prompting traders to further scale back bets on a rate rise this month…Bets on a rate increase climbed to as high as 55 per cent following stronger than expected US inflation figures on Wednesday before edging back. They fell further after Warsh’s comments, declining from around 27 per cent to around 15 per cent on Friday [October 16], according to Fed funds futures.”

In other words, it is highly unlikely that the Federal Reserve is going to hike rates at their next meeting on October 28. Although we are told that the Federal Reserve is independent, the fact is that, like all human beings, members of the Federal Reserve committee responsible for monetary policy are subject to influence. Barring a major economic surprise, I suspect that the proximity of the U.S. Congressional elections on November 4 reduces the likelihood of a rate increase at the October meeting. The last thing the Federal Reserve likely wants to do is draw attention to itself just days before an election, as its actions could be interpreted by some as favoring one group over another.

Having said that, I fully agree with Goldman Sachs’ economists that:

“’[a]longside other recent comments from FOMC participants, Warsh’s comments indicate that the FOMC is set to pause in October,’ economists at Goldman Sachs noted, adding they expect officials to raise rates at the Fed’s final meeting of the year in early December.”

In my view, the question is not whether rates will rise, but whether the Federal Reserve chooses to wait until after the election before taking further action. I think they will wait.

Decoding U.S. Inflation: What Headline CPI vs. Median CPI Tells Us About the Economy

The U.S. Bureau of Labor Statistics published the September 2026 Consumer Price Index for All Urban Consumers (CPI) on October 14, 2026, showing that the index “increased 0.6 percent on a seasonally adjusted basis…after rising 0.4 percent in August…Over the last 12 months, the all items index increased 3.7 percent before seasonal adjustment.”

That increase is modest, yet it could lead some observers to conclude that inflation pressures are once again broadening across the economy. However, to better understand whether inflation is truly broad-based, it is helpful to examine the Median Consumer Price Index, which is calculated by the Federal Reserve of Cleveland. By comparing the 12-month headline CPI rate against the 12-month median rate, we can clearly determine whether price pressures are widening across ordinary household purchases or confined to a few outlier categories.

We accessed the St. Louis Fed FRED database to construct our graphs.

 

We show the headline CPI (solid blue lines) by cumulative price change over the preceding 12 months, landing at 3.7% in September. With respect to the Median CPI, it measures the middle (50th percentile) price change across all consumer categories. The Median CPI (green dash lines) currently stands at 2.8%. This data transformation allowed us to establish a like-for-like comparison. 

Historical Context at a Glance

Three periods stand out:

1. Jan-2021 to Mid-2022: Both Headline CPI and Median increased in tandem. This meant that inflation was pervasive and widespread across every sector of the economy, and that prompted aggressive rate hikes by the Federal Reserve.

2. Mid-2022 to Late 2024: CPI dropped rapidly, as the supply disruptions during COVID subsided; but Median CPI remained elevated, consistently running above Headline CPI. That dynamic meant that core domestic expenses took longer to cool, creating inflation “stickiness” that kept the FRB on hold.

3. Mid-2025 to Early 2026: Median CPI steadily broke lower, with both metrics converging on average around the 2% - 3% range.

Conclusion:

As shown by the latest data, Headline CPI has ticked up to 3.7%, which gives the impression that inflation is heating up again. However, the Median CPI remains anchored at 2.8%, which suggests inflation is not presently exhibiting the type of broad-based acceleration characteristic of a new inflationary cycle. The latest data does not yet support the conclusion that the economy has entered a renewed inflationary cycle. Of course, things can change rather quickly, but when it comes to an inflationary phase, we are not there right now.

Locking In Treasury Yields: Opportunity or Premature Optimism?

According to a recent Financial Times article, investors are increasingly buying US Treasuries as yields climb toward levels not seen in decades. The rationale is straightforward: many investors believe rates may not rise much further, making current yields an attractive opportunity to lock in income. With inflation expectations remaining relatively stable, real Treasury yields have risen to around 3%, a level that many portfolio managers view as compelling.

One aspect of the article that caught my attention was the graph showing the sharp rise in US real yields since 2021:

While many investors appear to interpret current yield levels as attractive, the chart itself does not clearly indicate that real yields have reached a ceiling. In fact, the trend over the past several years has been upward. If real yields continue to rise, it would suggest that nominal interest rates are increasing faster than inflation expectations. Such a development could indicate the presence of structural forces supporting higher interest rates. However, the chart itself does not identify the source of those forces.

A second observation concerns the argument that financial stress, particularly in Europe, could lead to capital flows into US Treasuries. This logic is understandable. During periods of uncertainty, investors often seek the perceived safety and liquidity of the Treasury market. Increased demand would tend to push Treasury prices higher and yields lower. However, it is also worth considering whether a future economic slowdown or sovereign debt concern could simultaneously increase government borrowing needs, adding more Treasury supply to the market. The eventual direction of yields may depend on which force proves stronger.

For that reason, the most interesting question raised by the article may not be whether current Treasury yields are attractive. Rather, it is whether investors are correctly assessing the longer-term forces influencing interest rates.

Conclusion:

If inflation moderates and risk aversion rises, today's buyers may be locking in attractive returns. If structural forces continue pushing real yields higher, however, today's yields may prove less attractive than they currently appear. On balance, I believe the risks are tilted toward higher yields. Time will ultimately determine which view is correct, but the debate itself highlights just how important the Treasury market has become to the broader investment landscape. 

What Does It Mean When Private Equity Sees Global Financial Crisis-Level Opportunities While Markets Appear Calm?

According to the Financial Times, 

"Dipan Patel, co-chief executive of UK-headquartered buyout group Permira, told the FT Private Capital Summit in London this week that deals cut after the dotcom crash and global financial crisis were ‘among the best’ ever. ‘We're right back there today,’ he said."

Patel's comments caught my attention because they suggest that private market valuations have become unusually attractive, comparable in some respects to opportunities seen after the dotcom crash and the Global Financial Crisis.

While this does not necessarily imply that another crisis is imminent, it does raise an important question: Why are experienced dealmakers finding opportunities today that remind them of periods following major market dislocations?

If private market opportunities are indeed becoming comparable in some respects to those seen after prior market dislocations, while the broader financial markets continue to function with relatively little visible stress, we should consider whether underlying economic and financial risks are greater than generally perceived. At a minimum, Patel's observations may suggest that pockets of stress are developing beneath the surface, even if a broader crisis has yet to emerge.

Why Higher Treasury Yields Do Not Necessarily Mean Economic Disaster

Dan Ivascyn, chief investment officer at Pimco, argues that a 6% yield on the 10-year US Treasury bond is a realistic possibility. He warns that such a scenario could trigger selling pressure in the bond market as leveraged investors unwind positions and other market participants seek to reduce risk. Higher yields could also place pressure on equity and credit markets. At the same time, however, he believes that further increases in yields may ultimately be constrained by investors seeking to lock in relatively attractive bond returns, particularly when compared with riskier assets. Ivascyn also highlighted sovereign debt markets outside the United States that appear attractive from a risk-reward perspective, including Australia and the United Kingdom.

In theory, higher interest rates are not necessarily bad. What matters is not only the level of rates themselves, but also the expectations surrounding them. Economies tend to struggle most when expectations become unanchored and conditions change abruptly. If markets broadly expect higher rates and those expectations develop gradually, businesses, consumers, and investors can adapt their behavior over time. Problems tend to arise when rates rise sharply or unexpectedly, creating imbalances that force participants to adjust all at once.

Think about a rush of water. The initial surge can create havoc, but over time the water settles and the disturbance gradually subsides. The same analogy applies to economic shocks. The initial disruption often triggers a rush for the exits, so to speak, as markets rapidly reprice risk and participants scramble to adjust. Eventually, however, markets establish a new equilibrium and adapt to the new reality.

My poster-child example is Turkey. Consider the following two charts showing consumer price inflation and real GDP in Turkey:

The purpose of this example is not to compare Turkey with other nations, nor to suggest that high inflation is desirable. Rather, it illustrates that economies are often capable of functioning even under extremely difficult conditions. Since 2021, Turkey has experienced annual consumer price inflation exceeding 20%, creating significant economic challenges for households and businesses. Yet economic activity continued, businesses remained open, transactions continued to occur, and the economy adapted, albeit painfully. In short, difficult economic conditions do not necessarily imply economic paralysis.

Conclusion:

The takeaway from all this is that while higher Treasury yields would almost certainly create economic and financial market disruptions, disruption is not the same thing as collapse. In my view, one major factor that can increase the probability that a disruption turns into a collapse is ineffective government intervention, but that is a story for another day. Suffice to say for now that adjustment can be painful, and some sectors may experience greater stress than others, but economies generally adapt to changing conditions over time. A 6% 10-year Treasury yield would likely present meaningful challenges for markets, businesses, and consumers, but it does not automatically mean that an economic catastrophe is inevitable.

Higher Rates, Higher Risks: The Growing Pressure on Corporate Borrowers

According to the Financial Times,

“A sharp sell-off in US government bonds is starting to reverberate across corporate America, forcing companies to overhaul their borrowing plans and even raising the spectre of defaults among the most lowly rate businesses.

Borrowing costs for companies with the lowest credit ratings hit their highest levels since May 202 this month at 17 per cent, driven by the rise in Treasury yields to multiyear highs and by investors demanding more compensation for lending to such businesses. The risk premium for groups rated triple C or lower has risen to 12 percentage points, the biggest since 2022.”

This prompted me to examine the data myself and assess whether the evidence supports the Financial Times' conclusions.

My Analysis:

When companies borrow money in the bond market, the interest rate (or “effective yield”) they must pay depends on their financial strength. I analyzed three distinct corporate tiers:

• US Corporate (Investment Grade): Consisting of solid, blue-chip corporations with strong balance sheets.
• BB High Yield: Consisting of mid-tier companies with higher debt but stable businesses.
• CCC & Lower High Yield: Consisting of higher-risk or financially strained companies with the highest borrowing costs. These were the ones that were of special focus in the Financial Times reporting.

To easily compare how fast borrowing rates have grown across these different tiers in 2026, I indexed all yields to a baseline score of 100 on January 1, 2026. The way to read this index is to think of 100 as the starting point. If the index rises to 120, it means that tier’s interest rate increased by 20% from where it started in the year. This helps us see which companies saw their borrowing costs rise fastest in percentage terms and whether all rates moved up and down at the same time.

Take a look at the graph, courtesy of the data obtained from the St. Louis FED FRED database:

What the Numbers Show:
Early 2026 (January – May): During the first five months of the year, all three credit tiers move together in a tight band between 100 and 112.

Mid-to-Late 2026 (June – October): Starting in June 2026, the lowest-rated debt (CCC & Lower) broke away and shot upward. Given the dynamics of the chart I’ve included (i.e., it is not a live chart with values that can be observed when hovering the mouse), I’m mindful that the exact values are difficult to see. However, roughly-observing:

• CCC & Lower reached ~136 by October (a +36% proportional increase in its yield rate).
• BB High Yield rose to ~128 (+28% increase).
• US Corporate (Investment Grade) rose to ~124 (+24% increase).

How 2026 Differs from 2025:

In 2025 we saw High-risk companies enjoy a relatively lower rate pressure for much of the year (which you can see that their index spent long stretches down around 88), while mid-tier BB bonds saw the biggest spike in the spring of 2025.

In 2026 that dynamic completely flipped. In the second half of 2026, consistent with what the Financial Times reported, the most vulnerable companies faced the steepest rate hikes, seeing their borrowing cost surge much faster than those of safer corporations. Why? As Treasury yields have increased, so has the baseline cost of capital for all borrowers. Lower-rated companies often experience an additional widening of credit spreads as investors demand greater compensation for default risk. As a result, CCC borrowing costs can rise much faster than those of investment-grade issuers.   

Conclusion:

Refinancing Squeeze on Vulnerable Businesses: A +36% jump in borrowing rate levels means heavily indebted, lower-tier corporates face a severe increase in annual interest expenses when rolling over or issuing new debt. The open question becomes how many of these firms will be able to obtain financing.

Growing Caution in the Market: When investors demand much higher proportional yields from CCC-rated issuers compared to solid blue-chip companies, it signals heightened market concern about credit stress, debt serviceability, and default risks among financially vulnerable firms.

Should the upward trend in yields persist, I would expect default risk to rise across the corporate sector, particularly among lower-rated issuers that depend heavily on refinancing. At the same time, Investment Grade corporations may become increasingly selective in their debt issuance, acquisition strategies, and capital allocation decisions as financing costs rise. In that environment, higher borrowing costs would act as a drag on both corporate activity and broader economic growth.

QT, Sovereign Debt, and the Risk of a New European Credit Crisis

In a recent opinion piece, Lorenzo Bini Smaghi, former member of the European Central Bank’s (ECB) Executive Board and former chair of Societe Generale, raised the same sovereign risk concern I wrote about in a previous post. Given that Bini Smaghi served on the ECB’s leadership board during the onset of the 2011-2012 sovereign debt crisis, his warning carries substantial institutional weight.

His core thesis is straightforward: the ECB should stop shrinking its balance sheet (so-called Quantitative Tightening (QT)), because that forces private markets to absorb a massive amount of public debt at a moment when global bond yields are already volatile and trending upward. He also mentioned the risk of the classic “bank-sovereign doom loop,” where withdrawing central bank reserves from the banking system increases banks’ refinancing costs and inadvertently encourages them to hoard domestic government bonds.

Let me explain the “bank-sovereign doom loop,” because I also think it is an important risk to be mindful of, yet it is not discussed often enough. While both central bank reserves and government bonds count as High-Quality Liquid Assets (HQLA), reserves carry zero duration risk, whereas government bonds carry duration and spread risk. As QT drains cash reserves, some banks may increasingly rely on sovereign bonds to satisfy a larger share of their regulatory liquidity requirements (like the LCR). In a rising rate environment (or when sovereign spreads widen), the market value of those government bonds declines. This depreciation reduces the collateral value of those assets (requiring larger volumes and facing increased haircuts in funding markets), forces higher refinancing costs, and creates mark-to-market losses that directly impact bank capital. You now have a regulatory liquidity tool being turned into a catalyst for balance sheet and solvency strain (the “doom loop”).    

An Ominous Shift: When the Core Countries Look Like the Periphery:

What makes this warning particularly alarming is how closely the current market dynamics echo the early phases of the 2011-2012 Eurozone sovereign debt crisis, but with one critical difference. During the 2011 crisis, bond market stress and widening spreads were primarily concentrated in peripheral economies (unceremoniously the poster children referred to as the “PIIGS”: Portugal, Ireland, Italy, Greece, and Spain). Today, however, market pressures and spread widening are being observed in core EU nations, most notably France.

When sovereign debt risk shifts from smaller peripheral economies to systemic core countries, the nature of the threat changes entirely because the latter carry larger debt loads. In addition, EU commercial banks hold significant cross-border concentrations of core EU sovereign debt. Valuation strains in these assets could place pressure on bank capital and liquidity ratios across the entire continent.

Conclusion:

Should a renewed sovereign debt and banking feedback loop in the EU manifest, the second-order effects are likely to spill over into global financial markets. We could see:

• Global Liquidity Shocks: Rapid spread widening in Europe forces global institutional investors and asset managers to reallocate capital, unwind basis trades, and reduce risk across international fixed income markets.
• Spillover to the US and Global Yield Curves: EU bond volatility increases global term premiums, driving up borrowing costs worldwide and complicating monetary policy for other major central banks, including the Federal Reserve.
• Cross-Border Banking Contagion: International banks interconnected with EU counterparties face sudden counterparty and collateral revaluation risks.     

The precise transmission mechanism is less important. What is important is to account and plan for this sovereign debt risk.

Making Sense of Rising Sovereign Bond Yields: Separating Global Conditions from Country Risk

In a recent Financial Times article, the author wrote:

“Sovereign bond yields have been rising all year, and in the past few weeks the pace has accelerated across most developed markets. But there is not a clear consensus about what’s driving the sell-off. Looking at the most cited factors — inflation and indebtedness — across various countries reveals a mixed picture.”

The article also included these graphics:

 

The article struggles to explain why this sell-off is occurring simultaneously across different countries because its analytical framework is incomplete. To make sense of what is really happening, we can look through the lens of a classic financial tool: the 5 Cs of Credit Analysis.

The 5 Cs of Credit Analysis: From Bank Loans to Sovereign Nations

Lenders have traditionally used the “5 Cs” to evaluate whether a borrower is creditworthy. When applied to national governments (sovereigns), these five principles translate into key economic realities. Let’s take a look at each.

1. Character (Willingness to pay & Political Stability): Does the government have the political will, institutional stability, and governance to honor its debts?

2. Capacity (Economic & Fiscal Strength): Does the country generate enough economic growth and tax revenue to comfortably manage its debt load?

3. Capital (Fiscal Buffers): Does the government have ‘rainy-day’ reserves, such as foreign currency holdings or national sovereign wealth funds?

4. Collateral (Legal & Resource Backing): Collateral has limited applicability for sovereign borrowers because most sovereign debt is unsecured and governments cannot be liquidated in the same manner as private borrowers.

5. Conditions (The Global Macroeconomic & Geopolitical Field): What are the broader global trends, such as worldwide interest rates, commodity prices, and geopolitical tensions, affecting everyone?

My FT Critique:

The article tries to draw a connection between a single country’s debt ratio or inflation reading and its bond yield. In doing so, they run into contradictions. The reason is simple: they are looking for a simple correlation where the relationship is far more complex.  

Every country operates within two distinct layers of risk:

·     The Common “Playing Field” (Systemic Risk = Conditions): In my view, the primary driver behind the broad worldwide rise in bond yields is the global environment; that is, the fifth C, Conditions. When the global macroeconomic or geopolitical uncertainty increases, it acts like a rising tide. All sovereign bond markets feel the pressure simultaneously, regardless of their individual fiscal health.

·    Country-Specific Stories (Idiosyncratic Risk = Cs 1 through 4): While global “Conditions” shift the entire baseline upward, each nation’s domestic circumstances determine how its bonds perform relative to the rest of the world. I won’t go into detail for each country mentioned in the FT article, but let me mention two of them. In the US, bond yields climbed not because investors feared default, but because investors still perceive room for economic growth ('Capacity') and continue to view consumer demand as relatively strong. In France, bond yields increased near crisis levels due to political instability and election uncertainty (‘Character’), raising doubts about the government’s willingness and ability to control future deficits.

Conclusion:

We cannot judge a country’s bond market by looking at one or two numbers in isolation, as the FT article attempts to do. A broad-based sell-off in government bonds is primarily driven by global Conditions, i.e., the systemic forces that impact all nations at once. Meanwhile, a country’s Character, Capacity, and Capital dictate the specific risk premium and domestic story on top of that global baseline. By separating the global playing field from individual country fundamentals, we can gain a clear, coherent framework to understand what is truly moving sovereign bond markets.  

Economic Risk Dashboard: What the Numbers Suggest as-of October 2, 2026

Here I am showing what the Economic Risk Dashboard suggests based on data as of October 2, 2026. The data is sourced from the St. Louis Fed FRED database and I used my proprietary Python program to extract and analyze the data, as show below. For the conceptual foundation of the dashboard, read my previous post where I explain the framework in more detail.

The dashboard presents a mixed but generally stable picture of the US economy. At present, the dashboard suggests an economy that is not exhibiting broad-based stress, but one in which consumer sentiment remains exceptionally weak.

Household health remains solid, with unemployment at 4.2% and no evidence of deterioration in either the six-month or twelve-month trend.

Credit markets also continue to function normally, as high-yield spreads, investment-grade spreads, commercial paper spreads, and bank lending standards remain well below stress thresholds.

The one area that warrants closer attention is consumer confidence. The University of Michigan Consumer Sentiment Index remains near multi-decade lows, even as other indicators remain stable.

What Rising Treasury Yields and Falling Gold Prices Tell Us About the Federal Reserve

A few readers may notice an apparent tension between two recent articles I published.

In my September 14 article, I noted that oil price spikes associated with the Iran conflict appeared to be contributing to higher inflation expectations. Because nominal Treasury yields incorporate expected inflation, it is reasonable that Treasury rates would rise as investors reassess the inflation outlook.

However, a rise in inflation expectations does not automatically imply that inflation fears have become widespread or persistent. That was the focus of my September 30 article. The inflation measures and expectation metrics reviewed there, including Median CPI, 3-Year Expected Inflation, and the 5-Year Breakeven Inflation Rate, continue to suggest that inflation expectations remain relatively well anchored by historical standards.

At first glance, these two observations might look like a paradox: If inflation expectations are rising enough to push bond yields up, why wouldn’t gold rally on the same inflation fears?

The short answer is that inflation expectations and inflation fears are related concepts, but they are not the same thing. But the more detailed and nuanced answer lies in foundational economic concepts developed in the 1970s: central bank credibility and the difference between expected and unexpected policy.

Economists Thomas Sargent and Neil Wallace wrote a paper in 1975 called “’Rational’ Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule.” Sargent and Wallace argued that when market participants understand and anticipate a Central Bank’s reaction plan (they called this “systemic policy”), they adjust prices, contracts, and interest rates smoothly. In contrast, severe market dislocations and panics occur only when the Central Bank loses control and delivers unexpected surprises or allows inflation expectations to become unanchored.

In another paper called “Rules Rather than Discretion: The Inconsistency of Optimal Plans” published in 1977 by economists Finn Kydland and Edward Prescott, they argued that Central Bank credibility does not simply mean investors believe what policymakers say today. It means investors believe policymakers have the institutional discipline and incentive structure to stick to their commitments over time, specifically, keeping inflation under control rather than trying to engineer short-term economic booms.

In short, when markets trust a Central Bank’s long-term resolve, an increase in inflation is treated as a routine economic cycle rather than a structural crisis.

A picture is worth a thousand words. Look at the graphic below, as it will crystalize the two market dynamics that I highlighted in my two previous blog posts.

Why Treasury Yields Rose (The Bond Market Perspective) 

Treasury bonds pay fixed dollar payouts. If investors expect everyday prices to rise slightly over the coming years, they naturally demand higher interest rates on their bonds to offset the eroding purchasing power of future cash flows. Because investors viewed this rise in inflation as an expected, standard cyclical move, the bond market did what it was designed to do: smoothly adjust nominal yields higher to compensate for anticipated inflation and the FRB's monetary policy that follows.

Why Gold Fell (The Precious Metals Perspective)

Gold does not pay interest or dividends. Investors will rush into gold when they perceive heightened political risk and inflation risk. On the inflation risk side, two critical conditions that drive the price of gold are:

1. When investors fear a loss of FRB's credibility (currency debasement or runaway inflation).

2. When inflation-adjusted (real) interest rates fall to zero or negative, making holding cash less appealing than holding physical metal.

The available evidence suggests that neither condition was broadly present. Median inflation metrics showed that long-term inflation fears remained firmly bounded, and monetary growth was moderating. More importantly, because markets trusted the FRB to keep policy tight enough to fight inflation, real (inflation-adjusted) yields on government bonds remained attractive. With safe government bonds offering relatively solid real returns, the opportunity cost of holding zero-yield gold went up, putting downward pressure on gold prices.

Summary: Two Sides of the Same Credible Coin

Market Signal	What Happened	What It Tells Us About the FRB
Long-Term Treasury Yields	Rose	Markets are pricing-in anticipated cyclical growth and inflation.
Gold Prices	Softened	Markets trust that inflation will remain anchored, keeping real returns on bonds positive.
Monetary Base	Slower Growth	The FRB is maintaining balance-sheet discipline.

In summary, rather than conflicting, these two market behaviors are complementary pieces of evidence that investors continue to view the FRB as credible because:

·        The rise in bond yields showed that the market was pricing-in anticipated economic realities.

·    The weakness in gold prices suggests that investors generally continued to view the FRB as committed to maintaining price stability.

Conclusion:

When financial indicators seem to send mixed messages, it often pays to look beneath the surface. Inflation expectations can remain well anchored and not support the characterization that inflation fears have "roared back." The distinction is important. Markets may be pricing a somewhat higher inflation outlook than they were a few months ago, but that is very different from pricing an inflationary crisis.

Both trends point to one overarching reality today: the FRB’s policy credibility remains firmly intact.

Now, that reality can change. All we have to do is go back to the Great Financial Crisis of 2008 – 2010 to observe how reality changed quickly and suddenly.

The Possibility of a Sovereign Debt Crisis: The Risk Few Talk About

ZeroHedge published an article today on something that has been on my mind: the possibility of a sovereign debt crisis causing a contagion that would lead to massive financial losses. When I think of financial contagion, I often think of the Long Term Capital Management (LTCM) hedge fund crisis of 1998 that was precipitated by Russia’s currency devaluation. The LTCM losses were quite severe at the time and would have had a material impact on other financial institutions had the Federal Reserve not intervened.

History repeats itself, but only in rhythms. So goes the saying. I can envision a scenario where debt levels in Western nations hit an inflection point where investors attempt to sell their marketable debt while simultaneously demanding higher yields to compensate for default risk. This scenario is not far-fetched. It has happened in history, and there is no reason why it could not happen again. Of course, the circumstances surrounding such a scenario would likely be different this time, but the outcome would be the same: massive losses across financial markets because of their increased interconnectedness.

Look at these charts provided by ZeroHedge:

Italy vs. Germany Yield Spreads

 

France vs. Germany Yield Spreads

Conclusion:

Given the large debt burdens carried by many Western nations, some form of sovereign debt distress is a legitimate possibility. That distress does not necessarily have to take the form of an outright default. Governments may choose to monetize debt, restructure obligations, suppress yields, or pursue other measures that reduce the real burden of repayment. Regardless of the mechanism, investors may face losses if debt obligations are not honored according to their original terms.

A significant portion of sovereign debt is currently treated as low-risk collateral throughout the financial system. In a crisis, however, declining bond values could trigger collateral calls and liquidity pressures across highly leveraged institutions. Because modern financial markets are deeply interconnected, it is difficult to predict where stress will ultimately emerge.

The point is not to forecast every detail of a potential crisis. Rather, it is to recognize that the possibility exists and to take reasonable precautions before risks become obvious to everyone.

Have Inflation Fears Really Returned? Gold and the Message of Inflation Expectations

MarketWatch published an article on gold that was later reprinted in Morningstar news, where I came across it. Among other things, the article stated the following:

“The yellow metal has gotten hammered this month as oil prices have spiked and inflation fears have roared back, while technology stocks and even bitcoin - the very bets investors are supposed to flee in a panic - have ripped higher and helped underpin the broader stock market.”

I would like to address the "inflation fears" comment because the data from the past year do not fully support that characterization. Let me show you four charts obtained from the St. Louis FED Fred tool.

1. Monetary Base, which accounts for currency in circulation plus reserve balances. This is a proxy of how much liquidity the FRB has pumped into the financial system. Note: Red arrows are my notation.

Let's examine the increase in the monetary base between November 2025 and May 2026. During that period, the monetary base increased approximately 4.5% (=(160.9/154) - 1)*100), but then it declined to about 2.3% from May 2026 to August 2026. 

2. Median Consumer Price Index, which “according to research from the Cleveland Fed, the Median CPI provides a better signal of the inflation trend than either the all-items CPI or the CPI excluding food and energy. According to newer research done at the Cleveland Fed, the Median CPI is even better at PCE inflation in the near and longer term than the core PCE.” Note: Red arrows are my notation.

3. 3-Year Expected Inflation, which is a Cleveland Fed measure of expected inflation derived from Treasury yields, inflation swaps, inflation data, and survey-based measures of inflation expectations.

4. 5-Year Breakeven Inflation Rate, which “represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities (DGS5) and 5-Year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 5 years, on average.”

Charts 2 through 4 suggest that inflation expectations remain relatively well anchored alongside current inflation measures. If inflation fears were becoming widespread and persistent, we would likely expect to see a more significant increase in both realized inflation measures and inflation expectations.

Conclusion:

Gold is a political hedge and an inflation hedge. Currently, there is little evidence of broad-based accelerating inflation, nor do inflation expectations suggest such an outcome in the near term. In the political sphere, the behavior of gold prices suggests that investors may not currently be pricing a major and lasting economic disruption from the conflict.

Opportunity Cost of Illiquidity: Why Flexibility Has Value

At a conference today, I heard a term that immediately caught my attention. I must confess that I had never heard the phrase before, but it definitely resonated with me and left me thinking more deeply about its meaning and significance.

Let us define some terms first.

What is ‘opportunity cost’? It is the value of the next best alternative that we forgo when choosing one option over another. For example, the opportunity cost of investing capital in equities may be the interest income that could have been earned from a government security.

What is ‘illiquidity’? To answer that fully, we must look first at the definition of liquidity. Liquidity is the ability to turn some asset into cash quickly and without a high cost. Therefore, illiquidity means either the inability to convert an asset into cash quickly or the need to incur a significant cost in order to do so.

Putting this all together, the opportunity cost of illiquidity is the value of the opportunities that become unavailable because capital is locked in an asset that cannot be easily converted into cash.

The individual who mentioned the phrase said that investors either underestimate the ‘opportunity cost of illiquidity’ or ignore it altogether. Although the speaker did not elaborate further, I took his phrase to mean that, as investors, we must consider not only the investment we are about to make but also the alternative opportunities that may become unavailable once our capital is committed. In other words, many investors focus on the question, “What return will I earn from this investment?” but the real question should be, “What flexibility am I giving up by making this investment?”

When we talk about flexibility, we are in fact talking about optionality, which means the ability to react to crises, exploit opportunities, rebalance, or meet unforeseen obligations. Liquidity has value because it preserves future choices, and the opportunity cost of illiquidity is the loss of that optionality. An illiquid investment may earn 12%, but if that investment prevents you from deploying capital into an extraordinary 30% opportunity later, the true economic cost may be much greater than initially expected.

Conclusion:

Liquidity is more than a source of funding. It is a reserve of future possibilities. The opportunity cost of illiquidity, therefore, is not merely the inability to access cash, but the loss of opportunities that may arise while our capital remains locked away. This may help explain why experienced investors often maintain cash reserves even when attractive investments are available. The value of liquidity is not always apparent today, but it becomes obvious when unexpected opportunities emerge. Illiquidity does not need to have a negative connotation, but an adept investor may willingly surrender liquidity if he is being adequately compensated.

This concept applies not only to investing, but also to life in general. For example, taking a highly specialized job may create opportunity costs by reducing future career flexibility; or purchasing a home versus renting can involve an opportunity cost of reduced mobility. In that sense, liquidity and optionality are not merely financial concepts. They are frameworks for decision-making under uncertainty.