The United States has long relied on a strategy of anchoring its fiscal fate to key allies by encouraging massive holdings of Treasury securities in Japan and Europe, a mechanism that mirrors the famous "chained ships" tactic from the Battle of Red Cliffs. During prosperous economic times, this interconnected system appears stable and mutually beneficial, with allies supporting U.S. fiscal expansion while benefiting from relatively low borrowing costs. However, when a global stagflationary shock hits, the entire structure becomes dangerously vulnerable, as a fire on one vessel quickly spreads to all others in the chain.
Japan and Europe currently find themselves mired in stagflation, facing mounting fiscal burdens, depreciating currencies, and a steadily diminishing capacity to absorb additional U.S. government debt. The resulting gap in overseas demand for Treasuries is becoming increasingly apparent, and as market participants rush to reposition ahead of further deterioration, expectations begin to fulfill themselves. The rapid rise in long-term yields is, at its core, a run on the bond market rather than a reflection of fundamental supply dynamics.
Demand-Side Pressures Drive Treasury Yields Higher
Between late June and August, U.S. long-term Treasury yields experienced a notable surge, with the 10-year note climbing from 4.38% to 4.74% and the 30-year bond rising from 4.87% to 5.27% by August 21. The increase was more pronounced at the ultra-long end of the curve, suggesting a developing supply-demand imbalance in longer-dated securities. A comparison with the earlier rate cycle from February to May reveals distinct differences in the driving forces behind each episode.
During the February-May period, WTI crude oil prices soared 67%, and the 10-year yield rose 70 basis points, with inflation expectations contributing 24 basis points and real rates adding 46 basis points. In the more recent episode from June 29 to August 21, oil prices climbed 25%, the 10-year yield advanced 36 basis points, with inflation expectations contributing 12 basis points and real rates 24 basis points. While the elasticity of inflation expectations to oil prices has increased, the contribution ratio of inflation expectations to nominal yield movements remains nearly identical at approximately one-third in both cycles. However, the key distinction lies in the curve dynamics: the 30-year yield rose more than the 10-year in the current episode, whereas the opposite was true earlier in the year, indicating that term premium expansion rather than inflation expectations is the primary driver this time.
Notably, net issuance of long-term Treasuries has not expanded significantly. While total net issuance in July reached $355 billion, well above the monthly average of $195.8 billion over the past year, this increase was concentrated in short-dated securities, which accounted for $298.2 billion of the total. Net issuance of long-term debt actually declined to $29.2 billion, below the $33.5 billion monthly average, confirming that supply is not the source of upward pressure. The conclusion is clear: demand-side dynamics are driving the recent yield surge in long-term Treasuries.
Allies Chained Together Through Treasury Holdings
As of June, total U.S. government debt stood at $39.46 trillion, with foreign investors holding $9.30 trillion, or 23.6%, of the total. Europe, Japan, and China represent the three largest overseas creditors, holding $3.1 trillion, $1.1 trillion, and $0.6 trillion respectively, accounting for 33%, 12%, and 7% of foreign holdings. While China's long-term structural reduction in Treasury holdings reflects strategic geopolitical considerations rather than economic factors, the more immediate concern lies with Japan and Europe, whose capacity to maintain or expand their positions is deteriorating.
Japan's situation is particularly challenging, characterized by a wage-price spiral driven by imported inflation, labor shortages, and the institutionalized "Shunto" spring wage negotiations. External shocks have disrupted the entrenched expectation of price stability, with pandemic-era supply disruptions and recent oil price surges from Middle East conflicts feeding through to domestic consumer prices. The labor market has tightened considerably as the working-age population declines, with the active job openings-to-applicants ratio rising above the critical threshold of 1.0 and pushing companies to offer higher wages. Shunto negotiations have delivered pay increases exceeding 5% for three consecutive years through 2026.
The Bank of Japan has responded with a clear path of interest rate hikes, moving from negative rates and yield curve control in March 2024 through successive increases to 1% by June 2026. For over a decade, the BOJ's balance sheet expansion had effectively created a closed loop that absorbed government debt, with central bank assets growing from approximately ¥100 trillion to ¥750 trillion between 2010 and 2024, in lockstep with government debt rising from ¥900 trillion to over ¥1,300 trillion. The exit from YCC has broken this mechanism, and markets now recognize that the central bank can no longer absorb unlimited government issuance. This realization has triggered selling pressure on yen assets, accelerating currency depreciation, which in turn amplifies imported inflation in a self-reinforcing spiral.
Even as interest rate differentials between the U.S. and Japan have narrowed, the yen has continued to weaken, demonstrating that rate differentials are no longer the dominant driver of exchange rates when fiscal sustainability and sovereign creditworthiness are questioned. To stem the yen's decline, the BOJ must draw down foreign reserves, directly reducing its capacity to hold U.S. Treasuries.
Europe faces a similar stagflationary predicament, with energy and commodity prices fueling persistent imported inflation while high welfare spending maintains rigid fiscal outlays. Industrial competitiveness has weakened, and the economy struggles to generate organic growth, creating a low-growth, high-inflation environment. Rising government debt and expanding interest payments further constrain fiscal space, leaving fewer resources available for overseas asset allocation, including U.S. Treasuries.
The strategy of binding allies through massive Treasury holdings functions like Cao Cao's chained ships during the Battle of Red Cliffs. In favorable economic conditions, the system appears stable, enhancing America's fiscal capacity and suppressing yields. But when stagflation strikes, as it has this year, the vulnerabilities become apparent: fiscal risks in Japan and Europe transmit directly to the United States through the Treasury market. The bonds themselves serve as the chains connecting the vessels. While the U.S. faces relatively limited stagflation pressure due to its AI industry strength and high energy self-sufficiency, Japan and Europe are directly exposed, and their weakening capacity to absorb Treasuries is now visible to the market.
Once these demand-side pressures become apparent, other investors' willingness to allocate funds diminishes as well. The rush to reposition ahead of further deterioration becomes a self-fulfilling prophecy, and the recent rapid rise in long-term yields represents nothing less than a run on the market.
Fed Balance Sheet Expansion: The Only Near-Term Solution
America's fiscal and debt problems remain unresolved and are arguably worsening. The AI industry has not yet translated into improved tax revenues, with corporate income tax collections showing persistent negative growth and the overall revenue structure deteriorating. Total U.S. government debt has surpassed $40 trillion, and no meaningful debt reduction plan has been advanced, neither through spending cuts nor revenue enhancement. The fiscal fragility continues to mount.
In response to rising long-term yields, the Treasury Department has announced at least a doubling of its liquidity support repurchase operations for longer-dated nominal coupon securities, increasing maximum operation sizes from $20 billion to at least $40 billion. However, the signal value of this move exceeds its practical impact. Annual repurchase volumes of approximately $190 billion in 2025 and $170 billion year-to-date in 2026 are minuscule relative to the $40 trillion debt stock. Moreover, funding these repurchases creates inherent constraints: issuing short-term debt to finance long-dated purchases distorts the maturity structure and increases refinancing pressure, while reducing fiscal spending to fund operations would suppress aggregate demand and amplify economic downside risks.
Adding to the pressure, AI-related companies are competing for the same pool of long-term capital. The five major technology firms (Google, Amazon, Meta, Microsoft, and Oracle) issued approximately $35 billion in debt annually from 2020 to 2024, but this surged to $94 billion in 2025 and approximately $132 billion so far this year, including a roughly $53 billion multi-tranche offering that ranks among the largest corporate bond deals on record. Estimates suggest total AI-related debt issuance for 2026, including chipmakers, data center developers, and utilities, could range from $300 billion to $570 billion. With strong credit profiles and attractive yields relative to Treasuries, these corporate issues are crowding out long-term investment in government bonds.
The only viable near-term solution is Federal Reserve balance sheet expansion. By acting as the buyer of last resort for long-duration assets, the central bank can directly repair supply-demand imbalances, compress term premiums, and inject reserves into the banking system to ease liquidity strains. This approach would break the negative feedback loop of rising rates leading to higher interest expenses, wider deficits, and increased issuance. However, the side effects are significant: if inflation remains sticky, central bank purchases of government debt will be interpreted as fiscal deficit monetization, reigniting inflation expectations and damaging Fed credibility.
Balance sheet expansion is, at best, a temporary remedy. It addresses the supply-demand imbalance in the bond market without resolving the underlying fiscal problems, and it risks embedding long-term vulnerabilities including fiscal monetization, inflation resurgence, and erosion of dollar credibility. Once expansion stops, debt supply and fiscal pressures will push long-term yields back to elevated levels.
Over a longer horizon, technological and industrial prosperity offers the fundamental solution. Productivity gains raise potential growth, expand the tax base, and naturally increase fiscal revenues without requiring forced spending cuts. The debt-to-GDP ratio declines passively, fiscal sustainability improves, and investors no longer demand high risk premiums, allowing long-term yields to trend lower. The internet technology revolution of the 1990s provides a precedent: when productivity accelerated, U.S. debt pressures eased significantly. Simultaneously, industrial upgrading enhances production efficiency, expands goods and services supply, and suppresses long-term inflation persistence, allowing neutral rates to settle at lower levels.
In summary, balance sheet expansion addresses the bond market's supply-demand imbalance, while technological prosperity resolves the fundamental issues of debt, growth, and inflation. Central bank intervention can provide temporary relief, but long-term yields will ultimately be determined by economic fundamentals.
Renminbi and Gold: The Short-Term Answer
Until a transformative technological breakthrough drives renewed global prosperity, the dollar is likely to remain weak regardless of Federal Reserve policy choices. Rate hikes would increase short-term rates and directly amplify fiscal interest payment burdens, while rate cuts before oil prices decline would fuel inflation concerns and potentially push long-term yields higher. Balance sheet expansion, while alleviating Treasury demand pressures, would revive discussions of Modern Monetary Theory and raise questions about fiscal and monetary discipline that further undermine dollar credibility.
Not expanding the balance sheet may be the worst option of all. Having already committed to the MMT path, insisting on Fed independence would simply shift the burden to the Treasury, which faces limited revenue options. Forcing fiscal authorities to confront pressures alone would result in tighter spending and higher interest rates, likely detrimental to both the U.S. and global economies.
When the AI narrative begins to lose traction amid expectations of rising energy and food prices, the macro narrative of de-dollarization is likely to resurface. In this scenario, the renminbi and gold emerge as the most compelling short-term answers for capital markets. The renminbi benefits from a more resilient industrial structure and more prudent government debt management, while gold directly benefits from concerns about sovereign currency credibility. These assets offer a hedge against the vulnerabilities now exposed in the global Treasury market.