Rising Interest Rates Mean Deficits Finally Matter

The U.S. has long been the lender of last resort to the world. During the emerging-market panics of the 1990s, the global financial crisis of 2007-09 and the pandemic shutdown of 2020, it was the Treasury’s unmatched capacity to borrow that came to the rescue.

Now, the Treasury itself is a source of risk. No, the U.S. isn’t about to default or fail to sell enough bonds at its next auction. But the scale and upward trajectory of U.S. borrowing and absence of any political corrective now threaten markets and the economy in ways they haven’t for at least a generation.

That’s the takeaway from the sudden sharp rise in Treasury yields in recent weeks. The usual suspects can’t explain it: The inflation picture has gotten marginally better, and the Federal Reserve has signalled it’s nearly done raising rates.

Instead, most of the increase is due to the part of yields, called the term premium, which has nothing to do with inflation or short-term rates. Numerous factors affect the term premium, and rising government deficits are a prime suspect.

Deficits have been wide for years. Why would they matter now? A better question might be: What took so long?

That larger deficits push up long-term rates had long been economic orthodoxy. But for the past 20 years, interest-rate models that incorporated fiscal policy didn’t work, noted Riccardo Trezzi, a former Fed economist who now runs his own research firm, Underlying Inflation.

That’s understandable. Central banks—worried about too-low inflation and stagnant growth—had kept interest rates around zero while buying up government bonds (“quantitative easing”). Private demand for credit was weak. This trumped any concern about deficits.

“We had a blissful 25 years of not having to worry about this problem,” said Mark Wiedman, senior managing director at BlackRock.

Today, though, central banks are worried about inflation being too high and have stopped buying and in some cases are shedding their bondholdings (“quantitative tightening”). Suddenly, fiscal policy matters again.

To paraphrase Hemingway, deficits can affect interest rates gradually or suddenly. Investors, asked to buy more bonds, gradually make room in their portfolios by buying less of something else, such as equities. Eventually, the risk-adjusted returns of these assets equalise, which means higher bond yields and lower price/earnings ratios on stocks. That has been happening for the past month.

Sometimes, though, markets can move suddenly, such as when Mexico threatened to default in 1994 and Greece did default a decade later. Even in countries that, unlike Mexico or Greece, borrow in currencies they control, interest rates can become hostage to deficits, such as in Canada in the early 1990s or Italy in the 1980s and early 1990s.

The U.S. isn’t Canada or Italy; it controls the world’s reserve currency, and its inflation and interest rates are mostly driven by domestic, not foreign, factors. On the other hand, the U.S. has also exploited those advantages to accumulate debt and run deficits that are much larger than those of peer economies.

There’s not much sign that this has yet imposed a penalty. Investors still project that the Fed will get inflation down to its 2% goal. At 2.4%, real (inflation-adjusted) Treasury yields are comparable to those in the mid-2000s and lower than in the 1990s, when the U.S. government’s debts and deficits were much lower.

Still, sometimes bad news accumulates below investors’ radar until something brings their collective attention to bear. Could a point come when “all the headlines will be about the fiscal unsustainability of the U.S.?” asked Wiedman. “I don’t hear this today from global investors. But do I think it could happen? Absolutely, that paradigm shift is possible. It’s not that no one shows up to buy Treasurys. It’s that they ask for a much higher yield.”

It’s notable that the recent rise in bond yields came as Fitch Ratings downgraded its U.S. credit rating, Treasury upped the size of its bond auctions, analysts began revising upward this year’s federal deficit, and Congress nearly shut down parts of the government over a failure to pass spending bills.

The federal deficit was over 7% of gross domestic product in fiscal 2023, after adjusting for accounting distortions related to student debt, Barclays analysts noted last week. That’s larger than any deficit since 1930 outside of wars and recessions. And this is occurring at a time of low unemployment and strong economic growth, suggesting that in normal times, “deficits may be much higher,” Barclays added.

Abroad, fiscal policy has clearly begun to matter. Last fall, a proposed U.K. tax cut triggered a surge in British bond yields; the government scrapped the proposal, then resigned. Italian yields have risen since the government last week delayed reducing its deficit to below European guidelines. Trezzi said that for the past decade the European Central Bank had bought more than 100% of net Italian government bond issuance, but that’s coming to an end.

Foreign investors, worried about inflation and deficits, have been selling Italian bonds, while Italian households have been buying, Trezzi said. “With a weakening economy, it is unclear for how long…households can offset the selloff of foreigners.”

Investors looking for U.S. political will to rein in deficits would take note that both former President Donald Trump and President Biden, their parties’ front-runners for the 2024 presidential nomination, have signed deficit-busting legislation and that both of their parties have pledged not to cut the two largest spending programs, Medicare and Social Security, or raise taxes on most households.

They would also notice that the Republican speaker of the House of Representatives was just ousted by rebels in his own party because he had passed a bipartisan spending bill to prevent the government from shutting down. True, the rebels wanted less spending. But shutdowns, Barclays noted, represent “erosion of governance.” This isn’t how a country trying to reassure the bond market acts.

A sharp technology sell-off has exposed a new anxiety on global markets: whether the enormous borrowing behind the artificial-intelligence infrastructure boom can generate sufficient returns as interest rates rise and Chinese competition intensifies.

The artificial-intelligence investment boom has powered technology shares, semiconductor manufacturers and data-centre operators to extraordinary heights. Last week, investors were given a reminder that much of this expansion is being built with borrowed money.

The technology-heavy Nasdaq Composite fell 4.5 per cent over the week ended October 16, its weakest performance since late June. Semiconductor shares suffered an even deeper correction, with the Philadelphia Semiconductor Index losing about 11.4 per cent.

The selling spread quickly through global markets. Micron Technology fell 14.6 per cent over the week, while South Korea’s Samsung Electronics and SK Hynix dropped approximately 18 per cent and 24 per cent respectively.

This was more than a routine bout of profit-taking. Investors were reassessing three interconnected risks: higher interest rates, the rapidly expanding debt burden attached to AI infrastructure and the prospect of stronger competition from Chinese memory-chip manufacturers.

The debt behind the AI build-out

Artificial intelligence requires a physical infrastructure network of enormous scale. Data centres must be built, advanced processors purchased, power supplies secured and cooling systems installed before customers begin generating meaningful revenue from them.

Technology companies are increasingly supplementing their own cash with corporate bonds, syndicated loans, equipment leases, private credit and project-level financing.

JPMorgan describes the emerging funding model as a combination of conventional corporate borrowing and project finance tied to individual data-centre assets. In Australia, the Reserve Bank estimates that syndicated loans accounted for approximately three-quarters of data-centre financing during 2025 and 2026 to date.

The numbers are becoming large enough to affect broader credit markets. The Federal Reserve Bank of Dallas has cited Wall Street estimates suggesting AI-related investment-grade bond issuance could approach US$300 billion in 2026 alone.

That borrowing is not automatically problematic. Debt can be an efficient way to finance long-lived infrastructure when future revenue is sufficiently predictable. The concern is that AI technology, customer demand and computing economics are changing much faster than the repayment schedules attached to the assets.

A data centre financed today may carry debt for years. Investors must therefore make assumptions about future utilisation rates, electricity prices, chip performance, customer concentration and the amount businesses will ultimately pay for AI computing.

When interest rates rise, those assumptions become less forgiving.

Inflation changes the calculation

September’s US inflation data intensified the pressure. Consumer prices increased 3.7 per cent over the year, ahead of market expectations and up from 3.4 per cent in August.

The hotter reading reduced confidence that interest rates would fall quickly and pushed bond yields higher. That matters particularly for companies whose valuations depend on profits expected well into the future, as well as highly leveraged infrastructure operators that may need to refinance.

CoreWeave has emerged as a closely watched test case. The specialist cloud-computing company has accumulated substantial debt and lease obligations to build AI capacity, while relying on a concentrated group of large technology customers.

Its shares fell sharply during the sell-off, while the cost of insuring its debt against default climbed. CoreWeave has argued that its contracted backlog more than covers its obligations and that financial markets do not always understand its business model. Nevertheless, its securities have become a proxy for investor confidence in debt-funded AI infrastructure.

Oracle, another major investor in AI computing capacity, fell 8.8 per cent in Friday trading, while CoreWeave dropped 15.5 per cent.

The question is shifting from how much AI infrastructure can be built to how profitably it can be operated.

China adds another source of pressure

Interest rates were not the only catalyst. Reports of advances by Chinese memory-chip producer ChangXin Memory Technologies raised concerns that lower-cost Chinese products could increase competition across the global semiconductor industry.

Memory chips are essential to AI systems, but the industry is historically cyclical. Periods of tight supply and high pricing can encourage rapid investment, eventually producing oversupply and falling margins.

The prospect of a well-funded Chinese competitor expanding its technological capabilities unsettled investors in Samsung, SK Hynix and Micron. It also demonstrated that AI-related demand does not insulate chipmakers from conventional competitive pressures.

That combination—slower rate cuts, more expensive financing and potentially cheaper supply—challenged the assumption that every company exposed to AI would enjoy continually expanding margins.

A reset rather than the end of the boom

The sell-off does not establish that the AI boom is ending. Demand for computing power remains strong, the largest technology companies continue to generate formidable cash flows and many infrastructure projects are backed by long-term customer contracts.

What has changed is the market’s willingness to overlook the price and financing structure of that growth.

The most resilient companies are likely to be those able to fund investment from operating cash flow, secure long-duration customers and demonstrate that new capacity will earn returns comfortably above its financing costs.

More speculative operators may face greater scrutiny, particularly where debt is expensive, customers are concentrated or expected revenue depends on demand that has not yet materialised.

For Australian investors, the lesson extends beyond US technology shares. Local data-centre operators, infrastructure funds, electricity suppliers and property groups are increasingly exposed to the same investment cycle.

Artificial intelligence may remain one of the defining growth themes of the decade. But last week’s correction showed that enthusiasm for the technology does not eliminate financial discipline.

The next stage of the AI boom will be judged not only by computing power, model performance or demand for chips, but by something more traditional: whether the assets being financed can generate enough cash to repay the money borrowed to build them.

Fact box

Nasdaq Composite: Down 4.5 per cent for the week ended October 16, 2026

Philadelphia Semiconductor Index: Down approximately 11.4 per cent

Micron Technology: Down approximately 14.6 per cent

Samsung Electronics: Down approximately 18 per cent

SK Hynix: Down approximately 24 per cent

US September inflation: 3.7 per cent annually

Estimated 2026 AI-related investment-grade issuance: Approximately US$300 billion