One of my Diligence Wealth Club members asked:

It's a very good question. And I thought I want to share with my readers today.

First, while the Fed controls the short-term interest rates, long-term interest rates are driven by market forces - central banks, fund managers, banks etc. These institutions react to what’s going on in the world: massive surge in AI-related borrowings, ballooning government deficits, and threat of higher inflation from an ongoing war.

This makes long-term interest rates very sensitive. That’s why we’re seeing higher long-term yields.

Normally, this isn’t a problem. The Fed can print more money to buy back long-term Treasury bonds. This artificially keeps interest rates under control. It works very well when a country has a low public debt, which allows the government to easily service their interest costs on its debt. Pretty much what happened during the 1940s, when the US was even able to reduce its debt relative to the size of its economy.

However, today things are different. The US now holds a far larger amount of debt relative to its economy.

The US economy now sits on a whopping $40 trillion of national debt (including public debt). When an economy has an enormous debt load, the Fed needs to aggressively buy back bonds to move the needle. This has a lasting impact on the economy - a surging money growth chases that few goods and services, resulting in consumers facing the threat of rising inflation. The Fed stuck in a position to raise short-term interest rates to fight against inflation.

It can be frustrating. You see, when a country’s debt-to-GDP is significant, its government needs to pay a far larger interest cost even with a small rise in interest rates. That’s what 's happening in the US economy today.

Of course, this can be solved if the US economy grows fast enough to potentially pay down any rise in interest costs because the debt burden becomes a smaller share of the GDP. In other words, it used to be that the US could grow its way out of its debt. But not anymore. Since the 2000s, US fiscal deficits have been rising over the with fiscal spending (including interest costs) outpacing the government’s revenues.

Growing out of its debt is getting harder and harder.

This becomes a dangerous cycle. The financial institutions get investors' anxiety with higher US debt and they continue to sell off treasury bonds, forcing longer interest rates to climb higher. And if these big boys sell their bonds faster than the Fed could buy back them, the supply of bonds will exceed demand for bonds - interest rates go up.

This becomes a dangerous cycle.

Left unchecked, this is how the sovereign debt crisis takes shape: currencies weaken, inflation rises, and asset prices swing wildly. Consumers end up paying more in interest on their big purchases like cars, homes and even daily necessities. Spending gets cut back, and the economy slows down.

At this point, I’m bearish on the bond market. I believe this debt cycle will continue for as long as uncertainties around AI-related borrowings, and the ongoing war keeps on going. Remember in my earlier email newsletter on how the stock market is influenced by short-term interest rates? That's what will happen.

As an investor, my job is not to predict what Mr. Market is doing. Instead, start buying value, don’t pile up leverage, and stay patient. My take is start looking at stock opportunities where high-quality businesses that could continue to raise prices in midst of inflation - strong branding power.

Willie Keng, CFA

Founder, DividendTitan.com