How can the US bond market, home to the smartest money in the world, reconcile with 36 trillion in national debt and less than 2.5% expected annual inflation for the next decade? The answer may have two letters: A and I.
Four forces driving inflation:
- Debt continues to grow as a share of GDP and no political party has a credible plan to contain it.
- Building AI is consuming gigawatts, transformers, and copper faster than the grid can supply them.
- The war in Iran sent oil prices to a four-year low and lowered inflation in April to 3.8%.
- And we have a president who announces tariffs at breakfast and withdraws them at lunch.
Either of these should restore inflation to the front burner. Together they are terrifying.
Look at the chart. The red line is the national debt. It has tripled. From 35% of the economy’s size to 100% in 20 years. The green line is what the bond market expects inflation to be. It went from 2.4% to 2.45%. It’s not a mistake. Only 20 basis points in 20 years.
The bond market has been telling the same inflation story since George W. Bush’s second term. With three presidents, two financial crises, a pandemic, and the highest inflation in 40 years.
For most of those 20 years, the four armies did the job of fighting inflation. The Federal Reserve earned its credibility by suppressing inflation in the 1980s and has defended it consistently since then. Globalization has sent cheap goods from China and cheap labor from everywhere, and that has quietly driven down prices. The country was aging, which eased the demand. And the big foreign banks are buying our debt no matter what, driving down the bond market.
Here’s the problem: all four of those forces are weaker now than they were a decade ago.
The Fed is under more political pressure than at any time since Nixon leaned on Arthur Burns in the early 1970s. Kevin Warsh was recently sworn in as Fed chairman after the most divisive Senate vote in the institution’s history.
Globalization is going the other way. Prices are high, companies are bringing production home, and the US and China are drifting apart economically. The old guidance reduced prices. The new way is pushing them higher.
Aging is slower here than abroad, and limited immigration strengthens the labor market. Meanwhile, external demand for our debt is shrinking as China and the Gulf states quietly move away from dollars.
Four pillars, all cracking at the same time. It’s enough that you can expect bond brokers to take notice. Suffice it to say that they have to demand greater compensation for inflation than before.
However, they are not. The green line has not gone away. The bond market remains priced at about 2.45% inflation over the next 10 years. About the average for the last 30 years. Professionals never slack off. Is the market missing something? Or, perhaps, the market is betting on AI.
Not on Sam Altman, not on Nvidia’s next earnings report, not on whether ChatGPT can write your kid’s college essay, but production. On the assumption that AI will deliver more output from the same workforce, costs have lowered the overall economy. A shift big enough to absorb the financial meltdown and keep prices stable. That’s the bet baked into the green line. Whether you’ve thought about it that way or not, you’re either riding or fading.
Is AI betting good?
The case that the market is fair is straightforward. AI is replacing staffing in white-collar service sectors that have been fueling inflation: customer support, basic coding, radiology, drug discovery, all employee-centered information. Each of those is cheap and fast.
Do the math: one additional point of annual productivity growth over the course of a decade gives you an economy nearly 10% larger. Debt is stable as a share of GDP without reduction. And here’s the kicker: this is the only story big enough to clearly restore all four of those pillars at once. When the AI works, the anchor holds. If not, nothing else is big enough.
The case for bad betting is also strong. Production profit i half back in commerce. The front end, which we’re currently living in, as I wrote recently in a column about AI capitalization, is ramping up like hell. Data centers consuming gigawatts, three-year waits for transformers, electricians making six figures, electricity prices rising across the board. The bill comes first. The payoff comes later. It is possible.
Productivity gains take longer than anyone expects. The personal computer was on every desk in the 1990s. A productivity gain did not appear in the data until 1995. In 1987, the economist Robert Solow joked that you could see computers everywhere without productivity statistics. The same is true of AI today. It’s in every newsroom, every earnings call, and nowhere in the manufacturing data. Until now.
Stanford economist Erik Brynjolfsson argued in the Financial Times in February that the fog may finally be lifting. Job numbers for 2025 were revised down by 403,000 while Q4 GDP grew by 3.7%: the result increased, the flat of workers, which is the definition of productivity gains. His estimate: 2.7% by 2025, nearly double the previous decade’s trend of 1.4%. If he is right, the harvest phase has begun.
AI does not solve the inflation question. Expand the range of sound effects. When AI works, productivity gains absorb debt and inflation remains stagnant. If not, other pressures take over. A weak Fed. To reverse the trade. A big deficit. All prices rise simultaneously.
The bond market has made its choice. It’s not a bet on the Fed. It’s betting on GPUs. Experts are betting that AI will save us from debt.
So what should an investor do?
If you believe that AI will deliver a miracle to the bond market in its value, regular Treasury bonds are perfect. You’ll earn inflation-protected Treasuries (TIPS) for half a percent to a percent annually and pocket the difference. If you don’t fully believe it, TIPS with a real yield of 2% above inflation is cheap insurance. You stop coming back less than expected, and you sleep better at night.
If you can’t decide, and honestly who can, you own everything. A 50/50 split hedges your bets and protects you from being completely wrong either way.
And isn’t protection what bond investing is all about?
