Charts of the Week: The Cost of Capital Climbs

US Data Soften, and the Short End Takes Note One of the week’s most noteworthy developments has been the loss of momentum in the US data. Citigroup’s economic surprise index for the United States, shown in the chart below, has rolled over in recent weeks as activity releases — a disappointing employment report chief among them — have fallen short of expectations. The two-year Treasury yield, which reflects the market’s read on the Federal Reserve’s likely path, has moved a little lower in sympathy, as investors trim the odds of the further tightening that a hawkish July meeting had briefly put on the table. The message is that the short end of the curve remains, as it should, data-dependent and cyclical. What makes the present moment unusual is the contrast with the long end which, as some of the charts that follow help to explain, has been moving firmly in the opposite direction.

Japan’s Weak Domestic Demand Ties the BoJ’s Hands Japan sits awkwardly in the current conjuncture. The yen has fallen to levels last seen decades ago, and the pressure on the authorities to intervene, and on the Bank of Japan to tighten in the currency’s defence, has been building. Yet the latest national accounts, decomposed in the chart below, show why the Bank of Japan may hesitate. Growth has slowed through the first half of the year, and the composition is unflattering: private demand has been soft, and such growth as there has been has leaned heavily on net exports rather than on domestic strength. A central bank confronting a weak domestic economy is poorly placed to raise rates aggressively merely to support its currency, and that is precisely the bind in which the Bank of Japan now finds itself.

Rearmament Adds a New Claim on the Public Purse Among the structural forces now bearing on long-term rates, few are as visible as the marked increase in defence spending. The chart below sets military expenditure as a share of GDP in 2025 against its level three years earlier, and the increases are both broad and steep — most dramatic among the front-line states of Europe, where Poland, the Baltics and the Nordics have raised their burdens by two to three points of GDP in the space of three years. This is a large and, for the most part, non-negotiable claim on public resources, arriving when budgets are already stretched. Financed as it largely must be by borrowing, it adds directly to the supply of government debt that the world’s saving must absorb — and so to the upward pressure on the rates at which that debt is issued. For more discussion about this check out the analysis from Peter D’Antonio and Shashwat Indeevar in Efforts to Mitigate Military Risk Have Unintended Consequences.

Where the Strain Falls: The Sectoral Balances To see where these pressures come to rest, it helps to view the economy through the flow-of-funds accounts, in which the financial balances of the four sectors — households, companies, government and the rest of the world — must sum to zero. The chart below sets out that anatomy for the advanced economies. Households remain in surplus almost everywhere, and governments are in deficit across the board — the United States most strikingly. But the column that matters most is the corporate one. For two decades the corporate sector was a dependable net saver, quietly supplying the rest of the economy with funds; that is no longer uniformly so. Several of the majors — Germany, the Netherlands and Sweden among them — now show corporates in deficit, as firms begin to invest more than they earn. The significance is that the corporate sector is turning from a supplier of the world's saving into a competitor for it, just as governments remain the borrowers of first resort. With two of the four sectors now drawing on the same finite pool at once, the price of that saving — the real long-term interest rate — has every reason to rise.

And Where the Saving Is: The Glut, Now Chinese If governments are competing for the world’s saving, it is worth asking where that saving actually resides. The chart below traces the pool of global saving over time and, more tellingly, its composition. Two decades ago Ben Bernanke described a global saving glut concentrated in emerging Asia and among the oil exporters; that glut has not dispersed but concentrated further, with China’s share rising from around a twentieth of the world total at the turn of the century to more than a quarter today. This is the reservoir on which deficit governments and a reviving investment cycle must both draw. Whether it continues to be recycled into Western debt as readily as before — a matter increasingly bound up with politics as much as economics — will do much to determine how far long-term rates ultimately climb.

Will It Pay? The Productivity Question Our final chart brings the argument to its decisive question. A higher cost of capital is bearable if the investment it finances raises the economy's productive capacity, for then the growth arrives to service it. Total factor productivity — the part of output growth not explained by adding more capital or labour, and so the nearest thing economists have to a measure of pure efficiency — is where that payoff would show up. Raw productivity figures are hard to read over short horizons, however, because firms work their existing machines and employees harder when demand is strong and ease off when it is weak. The San Francisco Fed's series, shown in the chart below, separates the two effects: the pale bars capture that cyclical variation in the utilisation of capital and labour, while the darker line strips it out to leave utilisation-adjusted TFP — the cleaner read on genuine, underlying efficiency. It is the darker line that should give pause. Even as capital spending on artificial intelligence and its infrastructure has surged, underlying productivity growth has slipped into negative territory in the most recent quarters. It is early, and the gains from a technology of this kind may take years to appear in the aggregate data. But the figures are a reminder that the payoff on which the whole edifice rests is, for now, a matter of faith more than evidence — and that the cost of capital is rising regardless.