(The views expressed here are those of the author, an investment strategist at Panmure Liberum.)

LONDON - Long-term bond yields spiked globally last week, stoking fears about the ability of governments to finance their deficits. Sensible fiscal policies in Europe may stop this "doom loop" in 2026, but there is little reason to believe the U.S. will be so lucky.

Long-term government bond yields have been climbing steadily on both sides of the Atlantic in recent years. While this was initially driven by central bank rate hikes pushing real yields higher, bond yields have continued to rise in the last 12 months, even as central banks have started easing. Indeed, last week, 30-year U.S. Treasuries peaked at 4.99%, while 30-year UK Gilts rose to 5.69%, the highest since 1998.

The worry is that elevated long-term bond yields will make it harder for governments to service their expanding debt piles, which could eventually lead to a crisis.

Of course, interest expenses as a share of GDP are still well below the levels seen in the 1990s, so a government debt crisis anywhere in the developed world seems a long way off for now.

But if the rise in bond yields isn’t halted, businesses and governments alike will be forced to cut investment as debt service eats up an increasing portion of revenues. And that can create a doom loop where reduced investment lowers economic growth, reducing tax revenues, which, in turn, increases deficits even more.

EUROPE’S DEBT LOOP

European bond markets are already seeing the first leg of the dreaded bond yield loop play out, as higher government deficits have forced bond yields higher. This is especially true in France, where the government is facing a 5.8% deficit and has struggled to pass a budget.

Calming European bond markets over the long run will thus mean clamping down on deficits, which will likely require higher taxes, since cutting expenses is almost impossible when Europe is trying to rearm and improve its infrastructure.

However, many investors fear that raising taxes could lead to lower consumption, business investment and GDP growth, setting the damaging bond yield loop in motion. Yet there is reason to believe this loop will be broken in 2026, even if tax increases are necessary. That’s because European investments in infrastructure and defence are set to accelerate in 2026, and both usually have a large fiscal multiplier. That is, the output they generate tends to be larger than their cost, with benefits typically kicking in one to three years after the initial investments are made.

And since tax revenues are mostly driven by GDP growth, we can expect deficits to shrink in 2026 if economic activity picks up, especially if taxes are simultaneously increased.

In short, this is how to stop a bond yield loop. Governments engage in prudent policies that reduce the deficit and thus the risk premium on government bonds.

Of course, we all know such prudence can sometimes be in short supply.

US EXCEPTIONALISM

Much has been written in 2025 about the end of U.S. exceptionalism, but in one respect, the country truly does remain extraordinary. Unlike European countries, the U.S. appears to have no interest in decreasing its deficits. Rather, the U.S. remains on track for persistent deficits of 6.5% of GDP or higher. Unfortunately, this is apt to create an oversupply of Treasuries, leading to rising Treasury yields, particularly for long-term bonds.

And if long-term bond yields continue to rise, that will make it more expensive for businesses to finance capital expenditures, including the huge projected investments in artificial intelligence. And if some AI investments are curtailed, how will we see the sky-high corporate profit growth that investors are already pricing in?

Note that the above scenario does not even factor in the potential increases in inflation and lower growth that could result from the ongoing U.S. trade war. In other words, the fiscal imprudence of the new U.S. budget could be enough to keep the U.S. bond yield loop going.

So what could stop it? The Federal Reserve could engage in direct "yield curve control" to force long-term yields lower, international investors could develop an insatiable appetite for U.S. Treasuries despite the economic facts on the ground, or the U.S. government could reduce its deficit. Of these potential solutions, only the first — yield curve control — appears to have much of a chance of happening, and it would represent a significant change in U.S. monetary policy. Nearly a year ago, I wrote that long-term bond yields would keep rising despite the shift toward central bank easing. While I think Europe could break out of this trend in 2026, the same cannot be said of the U.S.

And if this divergence plays out, it would likely have significant repercussions for stock markets, particularly growth stocks, which are more sensitive to long-term bond yields than value stocks. While the outlook for U.S. growth stocks is thus getting darker, their European counterparts may soon see light at the end of the tunnel.

(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank).

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(Writing by Joachim Klement; Editing by Anna Szymanski and Lisa Shumaker)