Fed chair Jerome Powell did open the door to lowering the federal funds rate (FFR) in its September Federal Open Market Committee meeting later this week. He noted that emerging downside risks to the labour market and the “shifting balance of risks may warrant adjusting our policy stance”. (The Fed has a dual mandate: to maintain price stability and full employment.) The modestly dovish statement sent equity markets soaring (the Dow Jones Industrial Average hit a fresh all-time high that day), the two-year Treasury yields fell but yields on 10- and 30-year treasuries rose. In other words, the yield curve steepened as we had expected. Forcing short-term rates down in an inflationary environment will cause longer-term rates to rise.
This divergent reaction is perhaps unsurprising. Equity investors tend to be more short-term oriented, driven by narratives and momentum, storytelling and speculations. Bond investors, on the other hand, are generally more academic, economically minded and data-driven. Investors in long-dated treasuries demand a premium over short-term rates (the term premium) — to compensate for the time value of money as well as uncertainties in future inflation, interest rate and other risks. The latter includes any perceived loss of independence and credibility (due to political interventions) for the nation’s institutions as well as the central bank in conducting monetary policies. The term premium is not constant, and changes with market conditions, for instance, as expectations for future inflation and interest rates change.
Therefore, if the Fed is perceived to be succumbing to political pressures and/or lowering interest rates too early against the backdrop of rising inflation, there could be severe negative repercussions for longer-term investors. Case in point: Political pressure for the Fed to prioritise employment over inflation back in the 1970s contributed to a stagflationary environment that eventually required painfully high interest rates — and a deep recession — to restore price stability and the central bank’s credibility. More recently, in the case of Türkiye, the politicisation of its central bank — cutting interest rates amid a high inflationary environment led to soaring inflation, erosion of purchasing power, sharp lira currency depreciation and capital flight. In short, long-dated bond investors will demand higher yields as compensation when the perceived risks grow.
Tellingly, the steepening of yield curves is not limited to the US markets. The same phenomenon is observed for other major developed and highly indebted nations, including Japan, Germany and the UK. And has, in fact, been happening for more than a year (see Charts 1 and 2).
See also: The burden of knowledge
Heavily indebted developed nations are finding fewer buyers for long-dated bonds
Government attempts to term out debt have been met with market resistance. Yields on the 30-year UK bonds surged to the highest levels in nearly three decades in August, surpassing even the highs in September 2022 when former prime minister Liz Truss’ mini-budget triggered a bond market meltdown. The rising long-dated yields came despite the Bank of England cutting interest rates three times, a cumulative reduction of 75 basis points, so far in 2025.
Similarly, yields on the 20- and 30-year Japanese bonds also hit unprecedented levels. Earlier this year, the Japanese government was forced to cut back on long-dated bond issuances following weak demand in multiple auctions. And just two weeks ago, the premium on French 30-year bonds breached a level last seen in 2008. Even the traditionally safe haven 30-year German bund yield hit a 14-year high. As long-dated yields rise, the US has had to increasingly rely on cheaper short-intermediate duration borrowings to finance its deficits and refinance maturing debt (see Chart 3).
For the uninitiated, central banks control and influence short-term interest rates via their policy setting mechanisms. While long-term interest rates do take into account prevailing short-term rates, yields are ultimately determined by market forces of demand and supply. What is now happening is demand for funding from governments is outpacing public demand for long-dated bonds. This is due to a confluence of factors, including rapid ageing population and the end of quantitative easing programmes, whittling a key source of market demand for government bonds. More importantly, price-insensitive demand.
An increasingly aged population across much of the developed world will dissave, drawing down on their savings for consumption in retirement. Life insurers have less need for long-dated bonds and there is an ongoing structural demand destruction for long-dated bonds across Organisation for Economic Co-operation and Development (OECD) countries — as private pension funds shift from defined benefits (DB) to defined contribution (DC) models, as a result of the growing and increasingly unsustainable costs of rising life expectancy. For instance, the Netherlands, historically DB-dominant, passed a new pension law abolishing the DB accrual system in favour of a collective DC model. Dutch pension funds are among the biggest buyers of long-dated government bonds in Europe to match their long-term obligations. DC pension funds, on the other hand, typically take on more risks and favour higher allocations for equities and shorter-duration assets.
And then, there is the reversal of secular inflation downtrend that had persisted for more than three decades. Falling inflation was previously driven by cheap and cheaper goods manufactured in China. Case in point: US inflation ranged between 2% and 3% through the better part of the 1990s and 2000s and then dropped mostly below 2% to near zero after the global financial crisis — with interest rates following the same downward path — until the pandemic.
Trump’s tariffs are inherently inflationary; indeed, the intended consequence of tariffs to encourage reshoring of manufacturing. Prices in the US have started ticking higher. Most notably, the disinflationary influence from goods has reversed since April 2025, when tariffs started kicking in. We expect the effect will be more pronounced over the coming months as businesses replenish inventories (stockpiled before tariffs) and pass on rising costs. Note that the disinflationary impact from lower energy prices so far this year (compared to the average price of about US$80 per barrel in 2024) will soon taper off. We think further downside for oil prices is limited from current levels of around US$66 per barrel.
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As such, we believe US inflation will stay higher for longer. And so will long-dated interest rates. And higher-for-longer US interest rates — perceived to be the world’s “risk-free anchor” — will have spillover effects on the rest of the world, given that governments do compete for investor money (read the sidebar on why the rest of the world will likely suffer more from the higher interest rates and inflationary environment than the US).
High and rising government debt not fiscally sustainable
Costlier debt servicing is a huge problem for the many highly indebted nations and will lead to further deterioration in already overstretched fiscal positions. According to the OECD’s Government at a Glance 2025 report, the average fiscal deficit among OECD countries reached 4.6% of GDP in 2023, up from an average of 2.9% in the five years before the pandemic (2015-19). Many governments socialised private sector debt during the global financial crisis and the pandemic. Debt-to-GDP has risen sharply across the developed world (see Chart 4).
As we have previously written, the ratio of interest payments-to-government revenue in the US has risen from a low of 12% in 2021 to about 21.5% currently. We know total debt will continue to rise, and substantially too, based on Congressional Budget Office (CBO) projections. Trump’s One Big Beautiful Act is estimated to add US$3.4 trillion — excluding interest costs on the additional borrowings — to government deficits over 10 years. Moody’s projects that interest servicing could consume 30% of the federal revenue by 2035.
In Europe, nations have pledged to boost defence spending to 5% of GDP. As global economic growth slows, more governments will start to feel the pressure to provide greater fiscal stimulus to support domestic economies. Germany, for one, plans to significantly increase spending on infrastructure and defence to stimulate economic growth. The nation’s draft budgets for 2025-29 indicated net new borrowings of €82 billion ($123 billion) in 2025, €89 billion in 2026 and up to €126 billion by 2029. And that’s excluding the €500 billion special infrastructure fund.
All of the above amount to worsening fiscal positions. Clearly, the current trajectory is not sustainable. Governments must address the widening deficits and debt problem or risk it spiralling into the next great financial crisis. What, then, can governments do — what are the policy implications?
Outgrow debt — faster relative productivity gains and economic growth
The best way to manage the debt situation is to outgrow it over time — that is, by stimulating faster relative productivity gains and economic growth. But we know global economic growth is slowing.
This is where Trump’s MAGA Pathway comes into play. To be sure, there will be short-term pain. Consumers will face higher prices and consumption — and the economy — will likely slow (though we don’t think it will fall into recession). On the other hand, tariffs will boost government revenue and reduce imports, providing some immediate relief to deficits. Importantly, we believe that over the medium and longer term, tariffs paired with deregulation and lower corporate taxes will encourage investments (by both domestic and foreign companies catering to the US market), create jobs and raise exports — and improve the US trade balance with the rest of the world.
America and China are the two clear leaders in artificial intelligence (AI) innovations. We are convinced that continued advancements, faster and wider AI adoption will eventually boost productivity and lower costs. Make America more competitive in the world and support higher relative economic growth. Stronger economic growth that will, in time, reduce fiscal deficit and debt-to-GDP to ensure fiscal sustainability, and ultimately preserve US dollar hegemony. That’s why it is imperative that smaller nations like Malaysia raise productivity with pro-growth, market-driven policies — or risk being increasingly outcompeted and marginalised in the future AI-driven world economy.
Reduce fiscal deficit — cut back spending and/or raise taxes
The textbook policy prescription to quickly reduce fiscal deficits and government debt is through austerity — cutting spending and/or raising taxes. However, the reality is that policy options are often limited by realpolitik. This is especially pertinent in a democratic system where governments are elected every four to five years.
Obviously, most politicians will prioritise short-term popularism such as giving handouts. Deep spending cuts, on the other hand, are hugely unpopular with the people. Hence, it makes no sense for any prevailing administration to take the bitter medicine, and especially when economic growth is slowing, only to lose the next election. This is why few democratically elected governments will choose austerity. And history has proven that those who do usually suffer widespread public backlash, at times violent protests and even revolutions, and end up with huge electoral defeats. (We have an article lined up on the rationality of voters in a democratic election and its implication to policymaking.)
Raising taxes is also difficult in a world where capital can flow freely, especially when it comes to the wealthy. Case in point: The UK’s decision to increase capital gains tax rates in 2024 appears to have backfired. Capital gains tax income to the Treasury has fallen sharply since the new rates were implemented, compared to the preceding periods. Some have warned that current speculations of a wealth tax could further accelerate the exodus of capital, which could ultimately be counterproductive by hampering investments and growth.
Financial repression — suppress domestic borrowing costs
Therefore, the more likely solution to be adopted, we think, are financial repression measures — which combine fiscal needs with monetary/financial restrictions. There are various means through which the government can suppress domestic interest rates, to keep borrowing and debt servicing costs artificially low.
For instance, engineer a negative real interest rate environment by capping nominal interest rates and/or reporting low inflation numbers (incentive to under-measure inflation). Negative real interest rates will erode the real value of debt. Governments can also direct (or through moral suasion) state-owned institutions such as pension funds, insurers and banks to invest domestically, buy government bonds at artificially low interest rates. Other options include abolishing interest payments on bank reserves held by the central bank. More hardline measures would include fund flow restrictions and capital controls to keep domestic savings “trapped”, and in the worst case, getting the central bank to monetise government borrowings — though such actions will inevitably result in severe consequences for the nation.
Summary
There are growing worries over elevated public debt as a percentage of GDP, notably across the developed world, including the US. This is reflected in the steepening of yield curves — long-dated yields are rising even as central banks lower short-term interest rates. The era of cheap long-term funding is over, along with the end of secular decline in inflation. Persistent and high budget deficits and debt are not fiscally sustainable in the environment of rising interest rates and mounting debt servicing costs.
Worse, while the term premium has risen, it remains relatively low from a historical perspective (see Chart 5). Therefore, the term premium, we think, could rise even further to compensate for expectations of higher inflation and growing fiscal sustainability worries. Relentless pressure from the Trump administration on the Fed adds to the list of concerns — by threatening central bank independence in conducting monetary policies and the overall weakening of (and trust in) institutions. All these come at a time when government demand for funding is rapidly outpacing investor demand for long-dated debt. In other words, yield curves may well continue to steepen further.
High and rising borrowing costs amid slowing global economic growth increases the risks of a financial crisis and limits policy response. To return to more fiscally sustainable levels, the government should undertake fiscal consolidation (spending cuts and/or higher taxes). In a democratic system of government, however, the “ideal” fiscal policy (what is economically optimal) is always tempered by the realistic fiscal policy — how the people will react and what is politically achievable. And the reality is austerity often carries with it huge political costs. And historically few politicians are motivated to try.
To sell austerity, governments must turn to “storytelling”. In the US, Trump’s tariffs are politically sold as “protecting the American worker from unfair foreign competition, reindustrialise manufacturing and bring back jobs”. Even though studies show that it is the American consumers who will bear the bulk of the tariff costs (Trump insists that foreign exporters will pay). Lower-income groups will be disproportionately affected while the tariff revenue collected goes towards paying for tax cuts for corporates (enriching shareholders) and the wealthy. In other words, tariff is not only a consumption tax, but also a regressive tax on Americans. For Malaysia, it is called targeted subsidy, a redistribution of income from the wealthy to help the poor and improve equality.
We think most governments will ultimately choose the easier route — some form of financial repression. These measures are generally more opaque and, therefore, more politically palatable. Indeed, we have seen many such measures being undertaken before. But make no mistake, some people must pay. Maintaining artificially low or negative real interest rates penalises savers, including pensioners (whose savings are now earning negative returns after inflation). In effect, savers are subsidising the government and other borrowers (cheap financing).
A novel measure being promoted in the US is stablecoins under the Guiding and Establishing National Innovation for US Stablecoins (GENIUS) Act, which Treasury Secretary Scott Bessent believes is “a win-win-win for everyone involved: stablecoin users, stablecoin issuers and the US Treasury Department”. Encouraging rapid growth in stablecoin usage will lead to stronger demand for treasury bills, as part of the high-quality liquid dollar assets issuers must hold in reserves. This will help offset weaker demand from foreign central banks, including China, and keep yields lower than they would otherwise be.
Implications for investors: If long-term yields stay high — or rise further — duration bonds would be the obvious losers (bond prices are inversely related to yields). The longer duration the bonds, the more sensitive prices are to interest rate changes. Equities may fare relatively better, depending on sector. Bank stocks, we think, will benefit from a steepening yield curve — cheaper deposits while lending at higher rates at the longer end. In other words, higher net interest margins. On the other hand, property (and related sectors) will be the obvious losers — higher mortgage rates (typically benchmarked long-dated bond yields) will negatively affect home ownership affordability and housing sales. And smaller, highly geared businesses will be worse off than larger companies (with pricing power) and those sitting on cash.
Equity valuations especially for high-growth stocks would be hurt by higher discount rate, but the negative impact can be offset if earnings — sales and margins — can grow at a faster pace. Thus far, the US economy, margins and earnings for Corporate America have held up well. But higher-for-longer borrowing costs will eventually damp consumption. A sharp rise in long bond yields and/or slowdown in earnings can very quickly transform already pricey stocks to “shockingly expensive”. A good reason why we are cautious on the broader market.
The Malaysian Portfolio fell 0.2% for the week ended Sept 10. Gains from LPI Capital (+0.7%) and Hong Leong Industries (+0.6%) were more than offset by losses from Insas Bhd – Warrants C (-40%), United Plantations (-0.6%) and Kim Loong Resources (-0.4%). Total portfolio returns now stand at 184.5% since inception, outperforming the benchmark FBM KLCI, which is down 13.1% over the same period.
The Absolute Returns Portfolio performed far better, gaining 1.5% and lifting total portfolio returns to 38.2% since inception. The top three gainers were Alibaba (+6.6%), CrowdStrike (+6%) and Berkshire Hathaway (+5.3%) while the two losing stocks were Trip.com (-2.3%) and ChinaAMC Hang Seng Biotech ETF (-0.9%). We added Ping An Insurance to the portfolio, paring cash holdings to 30% of total portfolio value.
The AI Portfolio also fared well, up 1.5% last week. Total portfolio returns now stand at 4.8% since inception. The biggest gainers were RoboSense Technology (+7.9%), Alibaba (+6.6%) and Horizon Robotics (+5%). SAP (-3.8%), Workday (-3%) and Cadence Design (-2.5%) were the notable losers.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
