On Friday, Moody’s delivered a sharp warning to U.S. policymakers, downgrading the government’s credit rating from Aaa to Aa1.

While this is not yet the beginning of a full-blown fiscal crisis, it may very well represent the first spark that sets one in motion.

The bond market responded immediately. Today, the yield on 30-year U.S. Treasuries surged above 5% for the first time since October 2023, briefly touching 5.03% before settling just below that threshold.

This is not a trivial technical move—it signals that financial markets are starting to lose patience with Washington’s fiscal recklessness.

It’s the Level, Not Just the Change, That Matters

As most economists understand, it’s not merely the fact that yields are rising—it’s the relationship between interest rates and nominal GDP growth that determines debt sustainability.

The graph below illustrates this dangerous dynamic. When the interest rate on government debt rises above the nominal growth rate of the economy, the debt-to-GDP ratio starts to increase automatically. Without meaningful fiscal reform, this leads to an accelerating debt burden and, eventually, a loss of investor confidence.

This was precisely the trap that ensnared the PIGS economies—Portugal, Italy, Greece, and Spain—during the euro crisis from 2009 to 2015. Nominal growth collapsed, interest rates shot up, and debt burdens exploded. Fiscal austerity, IMF and EU bailouts, and a lost economic decade followed.

The United States is not there yet—but it is dangerously close to the critical threshold where markets will no longer tolerate inaction.

The Return of the Unpleasant Monetarist Arithmetic

Back in the 1980s, economists Thomas Sargent and Neil Wallace described the “Unpleasant Monetarist Arithmetic,” and it’s just as relevant today.

If fiscal authorities refuse to consolidate deficits, the central bank eventually becomes the only institution capable of preventing a sovereign debt crisis—by monetizing the debt. But that solution comes with a heavy price: higher inflation, currency depreciation, and the erosion of the central bank’s credibility.

This is not a theoretical concern. The Federal Reserve may soon face a brutal choice:

• Tolerate higher long-term interest rates and risk a fiscal doom loop.
• Cap yields through aggressive bond buying, risking a dollar crisis and elevated inflation.

Neither path is attractive. But unless fiscal policy changes dramatically, one of them will become unavoidable.

The Political Class Is Asleep at the Wheel

Rather than confronting the fiscal reality, the Trump administration is doubling down on pro-cyclical policies. The proposed “One Big Beautiful Bill Act” promises sweeping tax cuts that would add an estimated $3.3 trillion to the deficit over the next decade—with no serious spending reforms in sight.

Treasury Secretary Scott Bessent understands the risks, but he has failed to generate the necessary crisis awareness in Washington.

The Dollar’s Exorbitant Privilege Has Limits

The U.S. does have one major advantage over the PIGS economies: it issues the world’s dominant reserve currency and controls its own central bank. But that privilege is not unlimited.

If markets start to believe that the Federal Reserve will be forced into yield curve control (YCC) and large-scale debt monetization, the dollar will come under intense pressure. Capital will flee U.S. assets, the dollar will weaken sharply, and inflation expectations will rise.

A full-scale dollar crisis would likely unfold in five brutal phases:

1. Rising Term Premium and Yield Curve Steepening.
2. Sudden Capital Flight from Dollar Assets.
3. Forced Federal Reserve Intervention through YCC.
4. Surging Inflation and Loss of Dollar Confidence.
5. De Facto Debt Restructuring via Inflation.

This isn’t just theory—it’s the historical script from Latin America in the 1980s, the UK in the 1970s, and even the U.S. during the Great Inflation era.

We’re Not in a Crisis Yet—But the First Spark Has Been Lit

Let’s be clear: the U.S. is not yet in a full sovereign debt or dollar crisis. But the market signals are unmistakable, and the critical threshold is fast approaching.

The bond vigilantes have not fully reawakened—but they are stirring. And history tells us that when the bond market finally asserts itself, it does so quickly and mercilessly.

Washington still has time to avert this crisis. But that window is closing rapidly. If policymakers continue to ignore the warning signs, the fiscal reckoning may arrive far sooner—and hit far harder—than anyone expects.