The Marilyn Monroe Economy: Some Like it Hot

03 June 2025

Long phases of stability lead to episodes of instability as they encourage a build-up and unwind of leverage. Put another way, the period of ultra-low rates and the behavioural bias that it was a permanent state distorted fiscal behaviour, asset valuations, leverage, and investor expectations. The challenge today is that rates are no longer near zero. Indeed, the real (inflation adjusted) 10-year yield has been around 2% for two years (chart 1). The last time real yields were sustained above 2% was in 2005. That ended with the Great Financial Crisis. Historically, a 2% real yield was probably close to neutral or equilibrium. However, at elevated leverage, 2% real is very taxing.

Chart 1

Source: Bloomberg

The prevailing bias for most of the post-2008 regime and especially in 2016, was that low growth, low inflation and low rates was a permanent state. That consensus belief likely encouraged irresponsibly loose fiscal policy over the past decade amplified by the episode in 2020. Historically, the fiscal deficit moved inversely to the unemployment rate (the light blue line in the time series below is inverted below – chart 2). However, for most of period since 2015, the US fiscal deficit has been at “emergency” levels despite the labour market being close to full employment. Note that the divergence started under the first Trump Administration but was amplified under Biden.  

Chart 2

Source: Bloomberg

The challenge now is with debt-to-GDP over 100% the United States has likely moved into a regime of fiscal dominance - when interest rates rise, they increase the deficit faster than they slow private sector credit growth. Stated differently, the government's ability to borrow and spend, outweighs the central bank's ability to control inflation through traditional monetary policy tools. Early this year the Treasury Secretary discussed a period of “detox” or the unwind of forever and ever policy (deficit expansion). However, last month the Administration appeared to pivot back to “running the economy hot”  with the Big Beautiful Bill.

The consequence has been an impulsive 70 basis point rise in 30-Year Nominal Treasury yields to over 5% from the April low and an increase in the term premium. The pivot away from fiscal consolidation has likely amplified inflation expectations that had already increased sharply this year. One year ahead inflation expectations have increased to 7% in the Michigan Survey and the ISM Prices Paid index is consistent with an acceleration in headline consumer prices to around 5% (chart 3). Our sense is that expectations might be an emotional overreaction, especially if growth slows and the labour market slows. As we noted above, 2% real yields are very taxing.

Chart 3

Source: Bloomberg

The other consequence is for asset valuations, investor expectations and leverage. The current risk-reward in US equities is not very attractive at the 86th percentile of valuation range. Asset and investor return expectations that were predicated on the low-rate regime are also challenged by elevated and nominal real yields. Some might like it hot, however, the “good” outcome in this episode for bond investors and investors forced to hold fixed income (pension and insurance companies) for regulatory reasons, is a recession.  

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