Pushing East Asia to hike defense could boomerang on Wall Street

For years now, the United States has justifiably wanted its allies to pick up a bigger share of the burden of their own defense.

But as America now asks its partners to boost military spending to 5% of GDP, the sheer scale of these demands — especially on allies in East Asia — could push yields higher on U.S. Treasury bonds at a time when they are already under pressure by skeptical global bond investors and ratings agencies.

Back in 2018, President Trump wrote a letter to key NATO allies warning that the failure of major European members to meet a pledge to spend 2% of GDP was “not sustainable.” Russia’s invasion of Ukraine in 2022 pushed spending somewhat closer to that mark, and a recent sharpening of transatlantic differences on a host of other issues has led to a pledge by Berlin to increase spending on defense and infrastructure by no less than one trillion euros over the next decade.

America’s Asian allies should look to countries in Europe as a new-found example, Defense Secretary Pete Hegseth advised in his speech halfway around the world at the Shangri-La Dialogue in Singapore at the end of last month. “NATO members are pledging to spend 5% of their GDP on defense, even Germany,” he claimed, even if the actual details fall somewhat short of the promise.

Meanwhile, there is rising concern about events in U.S. bond markets where 30-year yields are approaching 5% alongside a falling dollar, an unusual combination that has not been seen in decades and one more commonly associated with emerging markets in the Global South.

And last month, ratings agency Moody’s downgraded the U.S. from its highest AAA rating, the last of the three major ratings agencies to do so. Drawing attention to a troubling debt trajectory, the agency said it expects “persistent, large fiscal deficits will drive the government's debt and interest burden higher. The US' fiscal performance is likely to deteriorate relative to its own past and compared to other highly-rated sovereigns.”

Moody’s focus on interest payment ratios suggests a key dynamic at play here — the combination of a large stock of debt with high interest rates pushes up the U.S. government’s interest rate burden, which, in turn, causes the stock of debt to grow even faster. And in a world with large flows of cross-border financial investment, what happens in one country’s economy and markets can easily spill into others.

In other words, the interest rate on U.S. government debt depends not just on the supply and demand for such debt within America, but throughout the whole world. Foreign holders accounted for roughly 30% of all Treasury debt in public hands at the end of 2024, holding $8.5 trillion of $28.1 trillion outstanding, with roughly 55% of such holdings in foreign private hands. For close to three decades now, public and private foreign demand for U.S. Treasury debt has helped hold U.S. interest rates lower than they might otherwise have been.

All of this could change in a hurry, driven in good part by Washington’s desire to shift patterns of global defense expenditure. As suggested in Hegseth’s remarks, not only does the White House want the U.S. to spend more; it also wants a massive ramping up in defense spending by all its allies, including Japan, Taiwan, South Korea, and other key partners in Southeast Asia, among others.

According to the Treasury’s latest report on foreign holdings of U.S. securities, the three East Asian allies held roughly $1.5 trillion, $650 billion, and $200 billion of long-term debt securities, respectively (largely Treasuries and mortgage-backed securities issued by the Government-sponsored agencies Fannie Mae and Freddie Mac).

Military spending increases around the world on the scale that the administration is pressing for could push up U.S. bond yields further, as allies borrow and spend more on their own defense, creating alternatives that can compete with Treasuries for global investors’ favor. Investors in U.S. allies might prefer opportunities closer to home and could also be subject to suasion by their governments to favor domestic bonds. Rising Treasury yields in turn could exacerbate concerns over the role of interest payments in the growth of U.S. government debt.

And, of course, bond yields are also a key driver of mortgage rates and thus of developments in the housing market — a key pillar of America’s political economy.

There could well be other factors in play that contribute to a reduced demand for U.S. assets. Sanctions and the impounding of Russian reserves helped lead to increased central bank demand for gold. And concerns about the unpredictability of U.S. trade policy have led even staunch allies like Japan’s finance minister to publicly muse about the leverage that country might hold through its ownership of U.S. bonds.

These impulses have not gone unnoticed in Washington, even as the administration’s own desires point in a few contradictory directions. It wants other countries to run smaller trade surpluses (implying less money to invest overseas) and take on more of the burden of their defense. At the same time, it wants the fiscal benefits of the low interest rates that derive from their subdued growth and their purchases of U.S. government debt, in addition to measures that increase American growth and revenues.

Attempts to square this circle have come down to suggestions such as allies buying very long-dated debt at below-market interest rates, increasing defense spending largely by buying more U.S. military equipment, or “paying” for the U.S. defense umbrella by just writing the U.S. government a check.

It is unclear how far such efforts will go given likely reservations in other countries about the extent to which they can depend on Washington, and the degree to which they see that broader economic and geopolitical interests are consistent with those of the United States.

Under such circumstances, rather than push for sharp increases in defense spending quickly, Washington could best meet its various goals by asking for a gradual increase in the share of the defense burden that is borne by its allies, even as it relies on diplomatic engagement to reduce the fiscal weight of that burden and supports and encourages their efforts to do the same.

Such a path would help reduce the risks to the United States and the world from a simultaneous rise in geopolitical and financial tensions.