Brad Rogoff: Welcome to another episode of The Flip Side. I'm Brad Rogoff, Global Head of Research. And joining me is Ajay Rajadhyaksha, our Chairman of Research. Welcome, Ajay.

Ajay Rajadhyaksha: Always nice to be on The Flip Side, Brad.

Brad Rogoff: Well, when the macro news is coming fast and furious, you get to join us quite often. Let's start a little philosophically here. So noted political commentator as well as big LSU football fan, James Carville, once famously said that he didn't want to be reborn as the President or the Pope. He wanted to come back as the bond market, because, and this is the, quote, bonds could intimidate anybody. And after the last few weeks, I'm starting to think he might have a point.

Ajay Rajadhyaksha: Well, you know, Brad, many of our listeners probably care more about the stock market than fixed income. But yeah, it's been an exciting few weeks in bonds, hasn't it?

Brad Rogoff: Well, unfortunately for those listeners, they're about to hear from a couple of guys who grew up in the fixed income market, which puts a little bit of pressure on me and you here to make the topic of today's Flip Side as interesting as possible to them. So I'll try and be a little dramatic here, and we'll talk about, is the US bond market starting to rebel?

So let me set the stage here for this drama. 30-year interest rates are within striking distance of their highest level since the global financial crisis. US mortgage rates are stuck at around 7%. And the US president is meeting with the Federal Reserve chair to tell him that he thinks rates should be lower.

Ajay Rajadhyaksha: Yeah. And moreover, let's remember that the US economy contracted in the first quarter. And you know this, Brad, weaker growth is typically bond friendly. Interest rates are supposed to fall. And yet, like you said, ten and 30-year interest rates in the US are now much higher than at the start of the year.

Brad Rogoff: All right. So I tried to sell the drama on the US, but it's not just the US actually, Ajay. So Japanese bond yields in the 30-year sector touched all-time highs in May. Japan, the land where the bond market basically went to sleep for decades, we're talking about there. And then you go in the UK, bond yields in the market that's commonly referred to as gilts, those are uncomfortably high as well. So this is becoming a global phenomenon. And I don't see how you can look at these levels and not think that the bond market is starting to rebel.

Ajay Rajadhyaksha: I'll take the other side, Brad. Look, I will concede that bond yields have risen more than expected this year. But ultimately, as it becomes clear that the economy is slowing, as central banks are still likely to ease as the months pass, US interest rates, I think, should fall.

Brad Rogoff: Well, exhibit A for me, Ajay, is the US debt picture. It is, politely I guess I will just call it, not good. Debt is now at 100% of GDP and rising quickly. The US has run deficits of 6%, 7% of GDP for the last few years and even with the jobless rate near 4%, and the economy is actually growing healthily.

Ajay Rajadhyaksha: Yeah, you are right on this point, Brad. I completely agree, the United States is only supposed to run deficits of this scale if the economy stumbles into recession. Tax revenues collapse and the government is forced into new fiscal stimulus. I get that.

Brad Rogoff: Okay. I'm glad we agreed on that, but I'm not quite done here. So the first step to stabilizing US debt is that the deficit doesn't grow faster than GDP. 4% is a reasonable long-term estimate for US growth. That's 2% real and 2% inflation. So deficit shouldn't rise at more than 4% of GDP. And the problem is if the current tax bill passes, the US is looking at locking in deficits of 6% to 7% for all of the next decade. Meaning US debt to GDP won't stabilize and it'll keep rising, likely for ten straight years. And that's assuming we're lucky enough to not have a recession over that whole period.

Ajay Rajadhyaksha: All right. So here is where I start pushing back a little. Your numbers are right, but are they new? Coming into the year, markets absolutely expected expiring tax cuts to be extended. If they were not, we would have seen a quick recession. And look, we all knew that extending the tax cuts will add around $4 trillion to the US deficits over a decade. But that was in the price. Now, yes, there are new tax cuts in the bill, but there's also some tax hikes. And once you add in tariff revenues, the ten-year deficit, Brad, is actually going to be a little smaller than bonds expected at the start of the year.

Brad Rogoff: I got two issues with that logic, Ajay. First, the Senate is likely to change the bill, and the path of least resistance is kind of always to water down any spending cuts. I mean, historically, if you're in the US Congress, you're like a game show host, a new car. Everybody gets a new car. The way to get votes to pass a bill is usually by giving everyone what they want, which balloons the cost of the bill.

Ajay Rajadhyaksha: That has been history; I just think the US Senate is unlikely to be too generous this time. Remember, the House barely passed their version with a one-vote majority. They will have to vote on the Senate version again. I just don't think the Senate bill will increase the cost of the bill much more. It's not politically feasible.

Brad Rogoff: All right. So now let's go to my other issue, which is tariff revenues. I know they could raise a couple of trillion dollars over the next decade. That's not chump change, that's a real amount of money. But how sticky are they? Just a few days ago, Trade Court struck down most of the tariffs. That got stayed, fine. But are they going to last past the Trump administration even if they're in place during the Trump administration?

Ajay Rajadhyaksha: On the court issue, the appeals court immediately issued a stay. Like you just noted, the president has alternative powers he can use to get the same result. And tariffs are a topic he has felt strongly about for over 40 years. He's not backing away from this policy. As for the next year's administration removing tariffs, well, do you remember the noise around the 2018 tariffs on China when they were first put on? Well, guess what? They never came off even under President Biden. Once the US settles at a level of tariffs, I just don't see them dropping very much. For one, we will get used to the revenues. And second, we will need those revenues very much in coming years.

Brad Rogoff: Okay. So even if that's the case, the US economy's fiscal indiscipline has already had consequences. So Moody's became the last big rating agency to downgrade the US a few weeks ago. And bond yields rose immediately.

Ajay Rajadhyaksha: I just don't think markets pay a lot of attention to rating agencies anymore, Brad. Not after 2008. Yes, interest rates rose after the downgrade, but they lasted for just a few hours. They were basically flat by that Monday. The reason why US yields ultimately rose the week of the downgrade was because Japanese bond yields made a new record high.

Brad Rogoff: All right. I noticed, Ajay, that you're not disputing my broader point here, that the US debt profile is set to keep getting worse for the next ten years, at least. But let's move on. Inflation is another big problem. The US has not been at 2% inflation in many years. Households are clearly growing nervous about rising prices, and now there's a surge in goods prices coming in the next few months. The US economy could run at 4% or 4.5% CPI in the summer. How are bonds supposed to ignore that?

Ajay Rajadhyaksha: Because this tariff-related rise in goods prices will be temporary, Brad. I know Chair Powell got a lot of flak for calling tariff inflation transitory, but you know what? He was right. Tariff inflation is transitory. Once it passes through the system, and it shouldn't be more than a few months, like you said, we go back to the underlying trend. And the underlying trend is actually good. The Fed's preferred measure, core PCE inflation, has run well below 2% annualized for the last two months.

Brad Rogoff: I was very confused by him using that word transitory, by the way. I thought the Fed had retired that one. But let's not spend time on that. I think the longer the US spends at above 2% inflation, the more the chance that financial markets also start to lose confidence about inflation. At some point, we all need to actually see inflation down to 2%, and without any of the now usual caveats. I'm also worried about foreign demand for US treasuries. China now owns far less than $1 trillion of US debt, so I guess you can take that as a positive or negative. And for all those news around China and US debt, China is now not even the second largest holder anymore. The largest is Japan; the second largest is now the UK. And if US trade deficits go down, foreigners will have even less incentives to recycle dollars into US treasuries.

Ajay Rajadhyaksha: That is true. Foreign demand for US debt has definitely gone down. And you're right, Japan is the largest holder at about $1.1 trillion, the UK is around $750 billion, China is a little lower. But again, I keep going back to this, Brad, this is not new. Foreign demand for US debt has been going down for years and years. This is not a surprise to bond investors in 2025.

Brad Rogoff: But the Japanese situation is new, Ajay. For decades, Japanese bond yields were so low that Japanese portfolios bought massive amounts of US government debt. But now bond yields in Japan have risen and they are likely to keep rising and stay high for a long period of time. The 40-year bond, for example, got to over 3.5% in yield. Still sitting over 3%, which is, at 3.5%, was a new high for Japan. How long before Japanese portfolios say, hey, all my liabilities are in yen, and now I can finally get reasonable yield in Japan. Why should I take the currency risk and keep buying US treasuries?

Ajay Rajadhyaksha: So I will admit, Japanese bond moves have definitely spilled over into US bonds in the last few weeks. But a couple of points. First, like you said, we didn't stay at that 3.5%. The Japanese Ministry of Finance came out with some measures and bond yields rallied a little. Second, there is still a sizable yield difference between US and Japanese debt. I mean, forget the 40-year, look at the ten-year point, which matters more. The United States still gives investors almost 3% more than Japanese bonds do. It's not easy to walk away from that.

And finally, look, we keep pouring over treasury holding data, what is called tick data, foreign demand at US bond auctions, and there is absolutely no sign yet that foreign demand has suddenly dropped sharply relative to, say, three months ago. Now, if Japanese ten-year rates rise another 1.5%, 2% points, yes, I will absolutely get concerned about the demand for US debt, Brad. But not here and not now.

Brad Rogoff: I think you're underestimating the demand challenges for US debt. It's a time when US financing needs are just rising and rising. So it's about that demand and supply. And don't forget, for most of the past 15 years, the Fed was a massive buyer and now it's a passive seller.

Ajay Rajadhyaksha: Yeah, you're referring of course to quantitative tightening, QT, but QT was its - was at its peak in the last few years and bonds handled it just fine. The Fed has already started slowing down its passive selling. I really think concern about demand for US treasuries at these levels is overstated.

Brad Rogoff: Well, not even I would just disagree, I think actually the US Treasury secretary would disagree as well. Secretary Bessent is clearly worried enough about demand that he has committed to only increasing issuance of very short-term bonds, what's called T-bills, just so he doesn't have to increase issuance of longer bonds like ten and 30 years.

Ajay Rajadhyaksha: Okay, so the first point I would make is that the United States is not the only country doing that. The UK is doing that, the Japanese hinted in that direction. I'm not denying that the US bond market does face challenges, but that is a price for everything, and I would argue that we are close to that price.

And the reason interest rates are here is mostly because the US is a victim of its own economic success. Markets think the US is strong enough that the Fed won't need to cut very much. They expect the Fed funds rate to only fall to 3.2% 3.3% at the bottom of this cycle. Well, if the Fed funds rate bottoms at 3.2%, ten-year yields don't seem out of place at 4.5%. As inflation eventually comes down, if the Fed has more room to ease, I think longer rates will fall too.

Brad Rogoff: So the way to get lower interest rates is for the economy to stumble. I think you're actually too sanguine, Ajay. It's definitely more risk being priced into longer US bonds, what's called term premium. And if inflation stays sticky, foreign demand keeps softening. And most importantly, the US doesn't get its fiscal house in order. The risk is that term premium will keep rising and push up interest rates.

But look, this is one of those very rare occasions where I really hope I am wrong and you are right. And that means a lot coming from me, I'm sure. We'll have to see how things play out in the bond market for the rest of the year. But for now, clients can read our latest views on bonds and the just published global Rates Weekly, titled, Unusual Uncertainty, available on Barclays Live.