A Fiscal Challenge in the Form of Rising Rates

By Sam Valverde, a nonresident fellow in the Housing Finance Policy Center at the Urban Institute

When people ask when fiscal concerns turn into a fiscal crisis, I usually start by resetting expectations. I don’t think we’re heading toward anything like what other nations or jurisdictions have experienced in terms of debt crises. I worked on the Puerto Rico fiscal crisis during the Obama Administration, which involved a debt moratorium, and I can tell you that is not a realistic outcome for the United States. Our Treasury market is over thirty trillion dollars outstanding, it is the most liquid bond market in the world, and the bedrock security on which global finance is built. A fiscal challenge for us won’t look like a default or a moratorium. It will look like progressively higher rates, policymakers losing the ability to shape the curve through statements and actions, and a Fed that finds it increasingly difficult to conduct monetary policy. These challenges would be significant, but they pale in comparison to how Argentina’s debt crisis unfolded, for example. But because all credit origination ultimately prices off the Treasury market, when the Treasury market sneezes, global finance catches a cold.

That is why the bond market matters to everyone all the time, including people who never think about it. Treasuries are the risk-free reference instrument, and everything else is built on top of them. Your mortgage tends to track the ten year Treasury for a simple reason. A thirty year loan rarely lives thirty years, and its useful life tends to run closer to seven to ten, so the ten year is the main ingredient in setting mortgage rates. It has become so important over the last year and a half because we’ve been waiting for rates to fall in housing, and they haven’t. The COVID response was necessary and it worked, breaking the back of what could have been a lasting recession, but it also set off inflation that policymakers first assumed was transitory and turned out to be anything but. I would much rather be fighting inflation after avoiding a deeper financial crisis than muddling through because the response was too weak. But inflation, once it sets in is persistent and sticky, and here we are fighting it again in 2026.

The most recent run-up in rates has several drivers, and the honest answer is that they compound each other. The conflict in Iran was the biggest shock, arriving at the end of February when most forecasters expected rate cuts this year. Constrained oil supply has a direct inflationary effect, and the uncertainty about when the conflict ends makes it impossible to price in a resolution. Layered on top of that, hyperscalers are issuing large amounts of debt to fund data centers and AI development, and those issuers are largely rate insensitive. Whether the bond rate is five, six, or eight percent, they will come to market because the payoff from AI development looks so certain to them. That absorbs institutional capital that would otherwise flow into Treasuries. Tariff uncertainty adds inflationary pressure, and all of it sits on top of a long-standing deficit spending that investors used to treat as an academic concern. It is a lot less academic now.

What I tell people to watch over the next six months comes down to two things. First, whether hostilities in Iran wind down, because right now the conflict is widening and expanding into other oil transit channels. A cessation would not take rates all the way back to where they were before, but it would remove a great deal of global uncertainty and lower the price of oil. Second, the fiscal plan the Treasury Secretary has said he is working on with the OMB director. It was first described as a matter of weeks and has since drifted to a matter of months, which to me suggests after the midterms. What the bond market will care about is credibility. A plan that shows real commitment from both the White House and Congress to a shared set of principles on raising revenue and reducing spending, something like a bipartisan commission process with buy-in from both chambers, would do more to calm markets than any single policy announcement. That kind of methodical, agreed-upon work is what long-term bond investors respond to.

There is also a mechanical reason this matters for the fiscal outlook. We issued a large amount of long-term debt during COVID at very low rates, and much of it is now maturing and has to be rolled over at today’s much higher rates. As bond rates rise, the cost of servicing our debt increases materially. Debt levels on their own are not necessarily unsustainable, but the trajectory is what investors are worried about. They can absorb the supply, again I don’t expect failed auctions. The issue is the price. Heavy supply means auctions clear at higher yields, which means rates keep drifting up until we see meaningful fiscal consolidation that reduces issuance and thereby reduces rates.

For housing, I don’t expect things to get better in the near term, and the risk is that they get worse faster. We are not entering this cycle from a position of strength. The origination market has been difficult for several years, liquidity is already strained for servicers, and making a new loan is only getting harder in a seven percent environment. Because housing is so personal and so political, I would expect a lot of policy activity aimed at mitigating high mortgage rates. The GSEs have already bought back MBS earlier this year, and the FHFA director has indicated that bond buyback activity will resume. Administrative solutions like that are likely to be discussed more actively if rates stay elevated, and we are clearly in an affordability crisis.

If there is one takeaway for people in the mortgage industry, it is that administrative fixes can move mortgage spreads at the margin but cannot substitute for addressing the fundamental driver, which is the fiscal trajectory and the rates it demands. The lenders and servicers who plan around a world of persistently higher rates, rather than waiting for an easing that depends on things outside their control, are the ones who will be best positioned to navigate what comes next.