Today, after the U.S. and Israel attack on Iran and the surge in tensions across the Middle East, this tail risk has moved from being one of the scenario analysis bullet points to something closer to a live stress test for the global macro framework.

The temporary closure of the Hormuz Strait, which channels a significant share of global seaborne oil trade, has triggered a sharp repricing of energy markets, with Brent and WTI surging in a matter of days and volatility in refined products spiking in tandem.

In other words, the stagflationary configuration I was describing as a risk case a few weeks ago now has a concrete transmission channel: an imported energy shock hitting an already anaemic European cycle.

The key question is not whether this shock will mechanically push inflation higher in the short term, I believe it will, but whether it will become something closer to a “war‑time stagflation” regime or remain a transitory level shock that central banks can afford to look through.

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In this piece, I want to approach that question not only through the usual macro narrative (growth, labour market, energy dependence) but also through the lens of rates markets: how have curves reacted in the euro area, and what does their behaviour tell us about how investors are pricing the balance between inflation risk and real‑economy damage?

Bunds and euro area AAA yields development

Conversely to the Russian attack on Ukraine in 2022, Bunds and EA yields behaved this time to the joint operation of U.S. and Isreal, quite differently.

Since 28 February (the day I take as t₀ for this shock), the 2Y Bund yield jumped by roughly 30bp in ten trading days.

→ Net result: a steepening of the 2s10s curve, moving us from a flat / mildly inverted curve into clearly positive territory.

In plain English:
the move is front‑loaded. It’s the short end that’s doing the heavy lifting.

Why does that matter? Because in rates-speak, how a curve steepens tells you why it’s steepening:

• If the long end blows out and the front end barely moves, that’s more like a pure inflation or term‑premium scare.

• If the front end jumps and the long end just tags along, that’s usually markets repricing the policy path - fewer cuts, maybe even a hike risk creeping back in.

This time, we’re clearly in the second camp.

You see the same story when you look at the Euribor rates. A month ago, the market was happily pricing a normalisation of the gentle ECB easing cycle, with the policy rate drifting toward something that looks like “neutral” over 2026. After the Middle East shock, those cuts get pushed out and shaved off. Depending on the day you look, the curve even flirts with a small probability of a hike by late 2026.

That’s a big change in a short time.

Nonetheless, euro long‑dated real rates are not screaming “we’re losing control of inflation expectations”. They’re saying something more subtle: “we think the ECB will lean hawkish again, even into a weak cycle, because 2022 is still in everyone’s head.”

In short: this doesn’t look like the curve panicking about long‑term inflation. It looks like the curve panicking about the path of the ECB, that is awaited this Thursday.

A quick and dirty event study

Now let’s be a bit more structured.

Whenever there’s a shock like this, I like to run a simple event study, using a Constant Mean Model.

Nothing fancy, but it forces you to answer a clear question: how unusual was the move we just saw, compared to what “normally” happens?

Here’s the setup I use:

• Two events:

  • Ukraine invasion: 23 February 2022.

  • Hormuz closure / Middle East escalation: 27 February 2026.

• An estimation window of 240 trading days before each event (roughly one year),

  and an event window of −10 to +10/+20 trading days around each date.

When you do that for both events and put them side by side, few things jumps out:

Oil price shock is greater and sharper this time

• The move in spot and near‑dated futures around Hormuz closure is bigger than what we saw in the first days after Ukraine invasion, even if the structural gas story was worse back then.

Short‑end Bunds behaved completely differently.

• Around the Ukraine invasion, the 2Y Bund actually fell on impact, we had a brief flight to quality moment before inflation and gas worries took over. Around Hormuz, there’s no such dip: the 2Y moves up almost immediately and pretty sharply. Investors weren’t surprised this time since already conditioned by 2022.

Curve steepening is stronger now than in 2022 but for different reasons.

• Same story for the 10Y, who fell on the news of the Ukraine invasion, before going back up. Around Hormuz, most of the steepening comes from the front of the curve, not the back. That’s the difference between “we’re repricing inflation for years” and “we’re repricing the next few ECB meetings”.

• This is confirmed when we look at the 10s2s slope curve. The flattening of the curve is well more pronounced this time than it was in 2022. Moreover, if the tension in the Middle East and around the Hormuz Strait continue to deteriorate, we could foresee a deepening of the 10s2s curve, unlike what happened during the invasion of Ukraine.

The move in the computed 1Y1Y forward rate is larger this time.

• If you look at a proxy for short‑term expectations (like a 1Y1Y forward rate), the 2022 shock pushed it down first before coming back to pre-invasion level. In 2026, the forward rate reacts much more.

  Additionally, a higher 5Y5Y after the event means medium‑term inflation risk is being repriced up, not just near‑term CPI. Markets now see more probability that inflation runs above target even 5–10 years out

  - but here many other factors other than the oil shock comes to play..

Are we in “stagflation of war” yet?

Let’s put the pieces together.

On the macro side, Europe is not in a great place:

• growth is weak,

• unemployment is drifting up at the margin,

• productivity is underwhelming,

• and the political backdrop (elections, fiscal rules, fragmentation, you name it) doesn’t exactly scream “policy agility”.

On the market side, the reaction to the Hormuz shock is telling you 3 things at once:

1. Short‑end rates are doing the heavy lifting.
   The front of the curve has moved a lot, which is code for: “we think the ECB will be more hawkish than we thought a month ago”.

2. The long end is relatively calm.
   Long‑term yields and the 5Y5Y forward have shifted up after event
   - but by a shorter absolute value compared to 2022.
   Investors are worried, and may value a real change in the world dynamic.

3. The curve is steepening more from the front, than from the back.
   That’s usually what you see when the market is re‑pricing the path of policy, not fundamentally re‑anchoring long‑run inflation.

Is that stagflation? Not quite.

At least not in the textbook sense where you get persistently high inflation + weak growth + rising long rates.

What we have right now is more nuanced and in some ways more dangerous:

• A fragile real economy,

• A central bank still traumatised by 2022, and therefore very sensitive to any hint of inflation re‑acceleration,

• And markets that price in that sensitivity by pushing up the short end and pushing out the timing of rate cuts.

If you sit at the ECB and remember how “transitory” aged, you can see the temptation: don’t blink, don’t cut too early, don’t let expectations drift. The risk, of course, is that in trying so hard not to repeat the 2021–22 reaction, you end up doing the mirror image: keeping real rates too high, for too long, into a shock that might have been more transitory than you feared.

Nonetheless, and obviously, the reaction of the markets and of the ECB will have a lot to do with how long the war in Iran and the tension around the Hormuz Strait stays alive.

As I write, Iran enters already its third week of conflict, while U.S. President insists the conflict is “nearing its end”. Though, prediction markets think the conflict may last a few weeks longer.

Where this leaves my base case

So where do I land after staring at curves and forward rates for too long?

→ I still think the central scenario is not full‑blown stagflation, in the sense of inflation spiralling while long rates explode. The 5Y5Y doesn’t clearly support that.

→ But I do think the distribution of outcomes has shifted further into uncomfortable territory, i.e. more probability mass in “ECB stays restrictive into a weak cycle”

From a trading / allocation perspective, that argues for:

• being very careful about short‑end duration (it’s where the policy tears are priced),

• monitoring the slope as your real‑time barometer of stagflation narratives,

• and treating any big jump in the forward rates (2Y1Y, 5Y5Y) as a warning light rather than background noise.

This week central banks are expected to announce their decision with

• Monday: Reserve Bank of Australia Day 1

• Tuesday: Reserve Bank of Australia Day 2, Federal Reserve FOMC Day 1

• Wednesday: Fed FOMC Day 2, BoC

• Thursday: BoE, ECB, SNB, Sweden’s Riksbank

I will closely watch those decision as they may shift narrative of monetary policy in the coming month, and I may keep building on this in the coming weeks.

In the meantime, if you found this useful, feel free to send it to the friend, a colleague.

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& don’t hesitate to engage if anything pops in your mind and wants to discuss it.

See you in the next one.

Yann

According to CBO (Congressional Budget Office), the federal deficit for the 2025 financial year will reach approximately $1.8 trillion, or around 6% of GDP, after 6.3% in 2024. Projections for 2026 estimate a deficit of $1.853 trillion, with a ratio remaining close to 6% of GDP, and an average projected deficit of around 5.9% over the decade.

However, this level of deficit is not occurring in the midst of a major recession or pandemic, but rather during a period of positive growth and still low unemployment. Whereas in the 1980s and 1990s this type of drift was reserved for periods of military effort or profound shocks, it is now becoming the new normal.

The same CBO projections and other analyses indicate that the federal debt held by the public will continue to over 100% of GDP at the end of 2026 and is expected to continue climbing in the 2030s without major correction.

This level is not unprecedented in itself (some advanced countries have already crossed these thresholds), but it is unprecedented for the issuer of the global reserve currency, historically perceived as “unconditionally risk-free”.

Interest charges are skyrocketing

As a share of GDP, data from the Federal Reserve Bank of St. Louis show that interest expenses have risen from around 1.5% of GDP in 2021 to over 3% in 2025, higher than the peak in the early 1990s. By the mid-2030s, several analyses anticipate interest payments will consistently exceed defence, Medicare and Medicaid spending.

In other words, a growing share of tax revenues is being used solely to service past debts, without funding a single additional teacher, soldier or hospital.

This is where the arithmetic becomes politically toxic.

The return of bond vigilantes: from theoretical concept to market reality

The term "bond vigilantes" was popularised in the 1980s and 1990s to refer to those bond investors who "do the law": when governments let deficits and inflation slip, they demand higher returns, forcing fiscal consolidation or a change of monetary course.

During the post-GFC decade, this power seemed to be neutralised by three forces:

• Massive purchases of central banks (QE),

• Global savings ("global savings glut"),

• And inflation permanently below the targets.

Since 2022–2023, these three shock absorbers have greatly weakened: central banks are reducing their balance sheets, excess COVID savings have been consumed, and inflation has surprised to rise in the long term.

Therefore, in the U.S. context, the narrative on bond vigilantes is coming back on the table, carried by the combination of deficits of 6% of GDP, debt >100%, falling key interest rates in an environment of still volatile inflation and political uncertainty (Tariffs, political pressure on Fed, Venezuela fate, U.S.-China/Russia rivalry, and newly Iran-War) may be a recipe for an aggressive reassessment of risk premiums on Treasuries.

Fed cuts but the US10Y resist

Normally, during a cycle of monetary easing:

• Fed funds fall,

• future rate expectations decline,

• and the entire curve flattens, particularly the 2Y–10Y curve, often via a bull steepener.

However, since 2024, this pattern has been significantly disrupted. Since the first rate cut in September 2024, the Fed has reduced its key rate by around 175 basis points, but the 10Y yield has only fallen by around 30-40 basis points, after even almost reached 5% in Q1 2025.

In short, the Fed send a clear sign of easing, but the market refuse to offer this equivalent narrative, especially on the long end of the curve.

To better understand this decoupling, we can decompose the 10Y as follow:

1. The mean of the short term yield over 10 year (expectation components)

2. The term premium (the compensation required for holding an asset with a long duration that is sensitive to debt, future inflation and political uncertainty)

Recent work by the FRED shows that after being virtually zero, or even negative, for several years, the term premium has returned to clearly positive territory in 2023-2025, reaching nearly 80 basis points at times.

In other words, even though the market fully expects the Fed to keep Fed funds lower than in 2023–2024, it is demanding an increasingly high yield premium to extend US duration. This rise in the term premium is precisely the sign of a partial awakening of bond vigilantes: it is not only current inflation that is at stake, but also the future sustainability of fiscal and monetary policy.

When debt really starts to ‘cost’ politically

The ‘political cost’ of debt manifests itself through three distinct but interrelated channels.

• Brutal budgetary arbitration

With public debt close to 100% of GDP, every sustained 100 basis-point increase in the average cost of financing ultimately translates into tens of billions of dollars in additional interest payments each year.

Politically, this means that, given fixed budgets, every 10Y period “held hostage” by the markets requires either higher taxes or lower visible spending, or the acceptance of an even higher deficit, which fuels the vicious circle.

• The “invisible tax” via long-term rates

The US 10Y rate serves as an implicit benchmark for the entire economy: mortgage rates, car loans, long-term corporate financing, discount rates in equity valuation models. A 10Y rate that remains stuck between 4.5% and 5% despite Fed fund rate cuts means high housing costs for households, marginally less profitable investment projects for businesses, and more fragile asset valuations.

This “invisible tax” does not appear in the finance bill, but it is felt by voters, which makes long-term interest rates politically explosive, especially in an environment of already high property prices and heightened inequality.

• Pressure on the Fed and the perception of independence

Finally, if the Fed continues to lower rates in a non-recessionary economic environment, under the pretext of supporting employment or responding to political pressure (notably from U.S. President Trump, who stated at multiple times that he wanted to see lower interest rate), the market may interpret this move as a dilution of its mandate of price stability.

This is where vigilantes become informal guardians of central bank independence: by refusing to lower long-term rates, they “punish” easing measures they may judged inconsistent.

3 market scenarios if the Fed cuts again and the 10-year does not follow suit

Scenario 1 – Bear steepener of defiance (the “bond vigilantes” scenario)

Assumptions:

• The Fed implements further rate cuts (e.g. −25 to −50 bp in total in 2026), officially to prevent a slowdown in employment.

  

• The deficit remains anchored at around 6% of GDP, with no credible consolidation plan.

• The White House pursues a pro-deficit agenda (tax cuts, new spending, costly protectionist measures via tariffs).

Typical market reaction:

• Fed funds ↓, 2Y ↓, 10Y–30Y ↗ or stable: bear steepener fuelled by the rise in the term premium.

• Likely market reaction:

  • Compression of multiples on US equities, especially growth/tech stocks with very long durations

  • Pressure on high-yield credit and leveraged loans (higher cost of capital, rising spreads)

  • Possible downward pressure on the dollar if foreign investors demand a higher premium or reallocate part of their reserves.

Political consequence:

• net interest becomes one of the largest items in the budget,

• increasingly polarised public debate over “who caused interest rates to skyrocket” (the Fed, the administration, Congress)

Scenario 2 – Credible soft landing (vigilantes remain on standby)

Assumptions:

• Additional Fed rate cuts are modest, in line with a genuine slowdown in growth and disinflation that brings core inflation back towards target.

• A minimum of fiscal discipline is shown (even if only symbolic): capping of certain discretionary spending, automatic rules to slow spending if growth picks up, etc.

Likely market reaction:

• Slight easing across the entire curve, 10-year–FF spread normalising but without excess,

• term premium receding, 10-year converging towards 3.5–4%.

In this scenario, bond vigilantes do not disappear, but they remain in the background, acting as a medium-term constraint rather than a crisis actor.

Scenario 3 – Growth accident or external shock (refuge prevails over discipline)

Assumptions:

• Exogenous crisis: major escalation in the Middle East, geopolitical shock in Asia, systemic banking crisis, etc.

• The Fed slashes interest rates and deploys liquidity lines, while investors desperately seek safe assets.

Likely market reaction:

• Massive rally in long-term Treasuries, decline in real rates, compression of the term premium, and Treasuries are once again becoming the ultimate safe haven.

In this case, the “disciplinary power” of bond vigilantes is overwhelmed by the safe-haven role of the asset. In the short term, long-term rates fall and political pressure eases... but the window for correcting the fiscal trajectory closes once again, making the system even more vulnerable to the next episode.

This last scenario can be largely amplified in the matter of a a long-standing implication of the U.S. in Iran. In the very short term, safe-haven logic still prevails: The strikes in Iran and the prospect of war are increasing demand for the dollar, the Swiss franc, gold and... Treasuries, as noted in several recent analyses from Reuters. At the same time, widespread tariffs and trade wars are increasing macroeconomic uncertainty, which is also driving some flows towards “safe” assets.

But this safe-haven demand coexists with factors that point to a higher risk premium: potential oil shock → risk of imported inflation, costly war in the Middle East (prolonged operations, support for allies, replenishment of arsenals), weakening global growth via tariffs → lower tax revenues → even higher deficits.

The real debt ceiling is the patience of the bond market

The United States remains, for now, in a grey area: long-term rates are high compared to the post-GFC decade, but far from the panic episodes of the 1980s and 1990s. However, several signals are converging:

• a deficit of 6% of GDP in ‘peacetime’,

• public debt >100% of GDP,

• interest payments that are already becoming one of the largest budget items,

• a term premium that has returned to a sustained positive level,

• and a long curve that no longer obediently follows the Fed’s impulses.

For a market investor, the challenge is twofold:

• On the one hand, it is important to understand that the 10Y US bond is no longer a pure reflection of Fed funds expectations, but increasingly, as we are talking today, a barometer of US fiscal credibility.

• On the other hand, it is important to recognise that the pricing of US sovereign risk is itself becoming a source of macro risk and cross-asset volatility.

Congressional Budget Office

FRED

Reuters - How US-Iran tensions could shape world markets

TE - Unemployment Rate

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Fiscal reform stands as one of the highest-leverage, yet most difficult, policy challenges facing developed economies. While necessary, public debt globally exceeds 92% of GDP with sovereign debt distress affecting over half of low-income nations, reform has become politically and structurally very complicated.
The Liz Truss mini-budget collapse in September 2022 serves as the contemporary example: a fiscally unsustainable expansion rejected by markets within 44 days at a cost of £30 billion.
Yet Britain's experience is merely the sharpest version of a broader dysfunction evident across Japan, France, and the UK in 2025–26. This article examines why reform fails through three interlocking lenses:

• political fragmentation that prevents consensus-building

• structural budget rigidities that eliminate discretionary room for manoeuvre, and

• investor skepticism that punishes fiscal incoherence with higher borrowing costs.

The evidence reveals a paradox: the countries most in need of reform are precisely those where political dysfunction makes it most difficult to achieve.

Political Fragmentation as the Primary Obstacle

The most immediate barrier to fiscal reform is political fragmentation. Political economy theory identifies this mechanism clearly: the greater the ideological distance between competing power centres, the less likely fiscal adjustment occurs1. France in 2025–26 exemplifies this dysfunction with acute clarity.​

For the second consecutive year, France failed to pass its budget within constitutionally mandated timeframes. On December 20, 2025, negotiations between government and parliament collapsed. The two lead budget rapporteurs, after more than 20 hours of negotiations, acknowledged failure: agreement existed on 259 of 263 articles and 44 of 47 budget areas, yet a single issue, the €6 billion corporate surtax (”IS surtax”), proved insurmountable. Left-wing parties demanded it; right-wing opposition rejected it. Prime Minister Sébastien Lecornu faced simultaneous threats of no-confidence from both the far-left La France Insoumise and far-right National Rally, with the far-left arguing “the primary responsibility for this failure lies with the government” and the right-wing accusers stating “the government has carefully made it impossible to reach an agreement.”​

This pattern illustrates a structural political failure: multi-party parliaments with polarised ideological flanks lack a natural legislative median. Rather than compromise, each extreme can threaten government collapse, forcing concessions that satisfy no one and resolve nothing. The resulting gridlock imposes real economic costs. Political paralysis reduced French GDP growth by 0.2 percentage points in 2025 alone. Public debt reached a new high of 117.4% of GDP; the EU Excessive Deficit Procedure remains active, mandating deficit reduction to 3% by 2029.

Japan’s recent election cycle reveals an identical dynamic. Prime Minister Sanae Takaichi announced her intention to dissolve parliament on January 17, 2026, calling snap elections for February 8. This dissolution serves a clear political purpose: by triggering elections before the FY2026 budget passes, it prevents fiscal discipline from being voted on in normal parliamentary circumstances. Instead, the election becomes a referendum on fiscal expansion. Takaichi’s pledge to suspend the 8% consumption tax on food for two years, at an estimated cost of ¥5 trillion annually, becomes the campaign centrepiece. The implicit message to voters is that fiscal constraints are negotiable during electoral cycles, undermining the long-term credibility of any fiscal consolidation target.

The UK under Liz Truss faced a different but related problem: not fragmentation in parliament (the Conservative Party held a majority), but a failure of the government itself to recognise political sustainability constraints. Treasury officials and independent forecasters - the Office for Budget Responsibility (OBR) - were not consulted before the mini-budget’s announcement. This procedural bypass was not accidental; it reflected ideological confidence that markets would reward unfunded tax cuts. Instead, markets correctly judged the budget “politically unsustainable” given that 60% of the population faced real income losses during a cost-of-living crisis while benefits accrued to high earners.

This common pattern across three major economies reveals a deeper political economy problem:

• governments and legislatures increasingly struggle to achieve the broad consensus required for credible fiscal reform.

When tax reform requires building coalitions across competing interests (wealthy individuals opposing progressive taxation, public sector unions protecting wage levels, pensioners defending entitlements, regional governments resisting centralisation) the political friction costs explode. Absent a major crisis or external shock that forces rapid action, reform deadlines slip and compromise proves elusive.

Structural Budget Rigidities: The Spending Trap

Even when political will exists, fiscal reform faces a second, more technical obstacle: the rising proportion of government budgets devoted to mandatory spending that cannot be easily adjusted. Budget rigidity, defined as spending locked into place by legislation, collective agreements, or constitutional provisions, now dominates advanced economy budgets.​

France exemplifies this constraint with painful clarity. Pension spending alone consumes 14% of GDP, among the highest globally. The 2023 pension reform, which gradually raised the retirement age from 62 to 64, was enacted via constitutional override (Article 49.3) following massive protests and strikes. This “wound on democracy,” as Prime Minister Lecornu himself later acknowledged, triggered sufficient political backlash that by October 2025, suspending the reform became politically necessary to prevent government collapse.

Yet suspending the reform imposed enormous fiscal costs. The finance minister explicitly stated: “Modifying the pension reform will cost hundreds of millions in 2026, and billions in 2027.” The projected cost was €400 million in 2026 and €1.8 billion in 2027. Sums that must be offset through other savings, yet political appetite to cut elsewhere (healthcare, social benefits, public sector wages) remains minimal.

The UK faces an analogous entitlement trap in its pension system, though structured differently. The “triple lock” mechanism ensures state pensions rise by whichever is highest: inflation, wage growth, or a fixed 2.5% floor. The Office for Budget Responsibility projects this policy will cost £15.5 billion annually by 2030, yet attempts to reform it face fierce political resistance from both pensioners and opposition parties. Chancellor Rachel Reeves has thus far declined to propose abolition despite the Institute for Fiscal Studies recommending exactly that.​

Japan’s structural spending rigidities run even deeper. Roughly one-quarter of the national budget is already devoted to debt servicing (the pure cost of past deficits) while aging demographics relentlessly expand social welfare spending. This leaves minimal room for discretionary adjustment without cutting healthcare, pensions, or other politically untouchable categories. As a result, rather than implement spending cuts, recent Japanese governments have repeatedly abandoned primary surplus targets.

The underlying constraint is that democratic governments cannot easily cut benefits already promised to large constituencies. Social security schemes, public employee contracts, and pension liabilities create “entitlements” in both the colloquial and legal sense, beneficiaries have acquired claims that courts, legislatures, and political norms treat as quasi-sacred. Cutting them requires either:

• (1) a major economic crisis that forces action (”fiscal imperative”);

• (2) generational changes that shift voter preferences; or

• (3) gradual phase-ins that spread pain across decades (the French approach), which themselves prove politically toxic.

The IMF has long emphasised that successful fiscal consolidations rely primarily on expenditure cuts rather than tax increases, spending reductions boost confidence and reflect “greater commitment” to fiscal discipline. Yet where spending consists overwhelmingly of mandatory outlays, this channel is blocked. The only alternative becomes tax rises, which face their own political resistance from vested interests and create economic distortions through inflation passthrough and reduced investment confidence2.

Investor Risk Premia: How Markets Price Political Dysfunction

A third, increasingly important constraint on fiscal reform operates through sovereign bond markets. Debt investors are now explicitly pricing political risk into government bond yields, adding quantifiable costs to fiscal hesitation and reform failure. This mechanism is now very visible in real-time market data.

Again, France provides the clearest evidence. Between July 2022 (when the ECB began hiking rates) and June 2024 (before Macron called snap elections), the average spread between French 10-year government bonds (OATs) and the German benchmark (Bunds) was 53 basis points, historically normal. Between the June 2024 snap election call and mid-October 2025, this spread averaged 74 basis points, a 21 basis point widening attributable purely to political instability.​

This widening reflects a sophisticated market mechanism. When Prime Minister François Bayrou called a confidence vote on August 25, 2025 (tied to his austerity budget proposal), the OAT-Bund spread spiked from 65 basis points to 82 basis points in a single trading session. The market was pricing in a 2–3 notch potential credit rating downgrade if the government fell and fiscal consolidation halted. After Lecornu took office with a compromise package, spreads eased but remained elevated around 70–75 basis points, reflecting continued uncertainty about whether parliament could pass a budget.

Critically, the composition of French bond investors amplifies this political risk premium. Foreign investors hold 55% of French government debt, well above comparable sovereigns like Italy or Spain. Of these foreign holdings, approximately 25% are held by foreign non-bank financial institutions (NBFIs), the investor class most sensitive to negative news and most likely to rapidly de-risk. This investor composition means that French political headlines translate directly and quickly into higher borrowing costs, creating a feedback loop:

• political dysfunction raises yields → this tightens financial conditions for the broader economy → growth weakens → fiscal situation deteriorates further → spreads widen more.​

Japan’s situation differs structurally but yields equally dramatic market consequences. Because Japanese Government Bonds are primarily held by domestic investors, banks, pension funds, the Bank of Japan itself, foreign-driven spread-widening is less pronounced. However, domestic investors can still revolt. On January 21, 2026, when Takaichi announced her consumption tax cut proposal and snap elections, Japanese bond investors staged a historic sell-off. The 40-year JGB yield surged to 4.0% (the highest level since 2007, when that maturity was introduced). The 30-year yield rose nearly 30 basis points in a single session. Weak auction results on 20-year bonds created a vicious cycle of “selling, heightened anxiety, and more selling.”

This Japanese bond rout had immediate global spillover effects. As Japan is the largest foreign holder of US Treasuries (over $1 trillion), forced liquidations to meet margin calls and rebalancing needs rippled through global fixed income markets. US Treasury yields spiked, and international finance officials scrambled to coordinate commentary. US Treasury Secretary Scott Bessent acknowledged that disentangling “endogenous” (US-driven) market moves from Japanese fiscal concerns was “very difficult.”

The market mechanism at work is straightforward: investors fear that political disorder will prevent fiscal consolidation, requiring either debt restructuring or inflation to reduce real debt burdens. This risk is priced into higher yields (and spreads), which raises future borrowing costs and tightens fiscal constraints. For countries with high debt stocks, this effect is acute. France at 117.4% debt/GDP cannot absorb a sustained 20+ basis point spread widening without seeing debt sustainability come into question.

UK markets, by contrast, have rewarded political credibility. After Rishi Sunak’s return to fiscal orthodoxy following Truss’s collapse, gilt yields stabilized and the UK moved toward the front of the “fiscal credibility” queue among major economies. The 2025 Budget’s emphasis on debt reduction and compliance with fiscal rules (current budget surplus by 2029/30) reversed market skepticism.

Debt Market Response and Contagion Risk

Investors are responding to these failures by raising term premiums across the sovereign bond curve. The IMF’s October 2025 Global Financial Stability Report highlighted this dynamic: “long-term sovereign bond yields saw upward pressure across advanced economies,” driven partly by rising fiscal deficits and investor de-risking. This is particularly acute in longer-dated securities, where political and fiscal risk premiums compound.​

France faces the highest immediate contagion risk. Should the country’s political paralysis persist, rating agencies (Fitch, Moody’s, S&P) face pressure to downgrade. A 2–3 notch downgrade would trigger cascading consequences:

• (1) institutional investors holding France would need to rebalance;

• (2) European banks holding French debt would face capital rule pressures;

• (3) ECB support via the Transmission Protection Instrument (TPI), designed to “counter unwarranted, disorderly market dynamics”, might be activated, further politicising monetary policy. However, the TPI has constraints: it cannot be used for countries subject to the Excessive Deficit Procedure (which France is), even if the ECB has legal discretion to override this.

For Japan, the risk is different but more systemic. A sustained loss of confidence in JGB markets could force the Bank of Japan into unlimited open-ended purchases to stabilize yields, further undermining inflation control. Alternatively, foreign investors might flee, forcing domestic financial institutions to absorb entire new issuances at yields substantially above international equivalents—a scenario that weakens the yen and raises import costs, particularly problematic during an inflationary period.

The UK, by contrast, demonstrates how clear fiscal commitment can stabilize markets. By embracing what financial markets reward—demonstrated commitment to debt reduction, adherence to multi-year fiscal rules, and credible fiscal institutions—post-Truss UK policy has been rewarded with lower yields and narrower spreads versus Bunds.

Why Reform Ultimately Requires Crisis

The evidence across these three countries points to a sobering conclusion: meaningful fiscal reform rarely occurs absent major economic or political crisis. The academic literature on fiscal consolidation supports this view. Analysis of large adjustments across a wide range of countries shows that most occur “against the backdrop of difficult macroeconomic conditions, including sluggish growth, higher debt, and high inflation.”​

Yet this dependency on crisis creates a policy trap. Governments can, and do, indefinitely postpone reform when conditions are merely difficult but not catastrophic. France’s debt has risen to 117.4% of GDP, its deficit remains above 5%, and its growth has been pressured by political uncertainty, yet there is no acute crisis forcing immediate change. Japan’s debt exceeds 230% of GDP, and debt servicing now consumes 25% of the budget, yet the political system continues to spend more rather than adjust. The UK endured reputational damage and market turbulence, yet crisis forced the change Truss’s ideology could not.

The deepest implication is that fiscal sustainability itself becomes a political choice, not an economic inevitability. Countries with deep institutional capacity, effective central banks, credible fiscal councils, broad political consensus on fiscal responsibility, can sustain high debt levels without crisis, as Japan itself has done for decades. Yet this capacity appears to be eroding. Political fragmentation, the rise of extreme parties, electoral cycles that reward spending, and declining institutional consensus around fiscal conservatism all undermine the political economy foundations that once enabled sustained consolidation.

Conclusion: The Rising Cost of Fiscal Inaction

The Liz Truss collapse remains the defining 2022 cautionary tale: what happens when fiscal policy violates basic macroeconomic principles and lacks political sustainability. Yet Truss’s brief tenure should not be misread as a problem unique to ideology-driven outsiders. France’s center-left government faces identical political obstacles to reform; Japan’s establishment leader Takaichi is making identical electoral-cycle fiscal promises; the UK’s post-Truss governments have themselves struggled to achieve the spending restraint necessary for their own fiscal targets.

The common thread across all three is this: fiscal reform has become politically nearly impossible absent major crisis, yet the constituencies demanding fiscal discipline—investors, EU institutions, credit rating agencies—have fewer levers with which to enforce discipline. ECB emergency tools like the TPI can stabilize bond markets in moments of panic, yet cannot force underlying fiscal consolidation. Bond spreads can widen to price political risk, yet do not automatically trigger investor flight (as France demonstrates—spreads have widened 20+ bp, yet debt sales are not crashing). Electoral democracy, in its current form, has few mechanisms for imposing multi-year fiscal discipline against present-day spending preferences.

The result is a sustainability dilemma: high-debt countries continue to accumulate debt despite obvious fiscal unsustainability; political systems fragment rather than coalesce around reform; and markets increasingly demand higher yields as compensation for political risk. This pattern will persist until either:

• (1) a major crisis forces rapid adjustment, as occurred in the UK with Truss;

• (2) institutional reforms (fiscal rules with teeth, independent fiscal councils with enforcement power) constrain political discretion; or

• (3) political realignment reduces fragmentation and creates room for centrist consensus on fiscal consolidation.

For investors and policymakers, the implication is clear: political fragmentation has become as much a fiscal risk as debt accumulation itself. Until this political economy constraint is addressed, fiscal reform will remain the hardest reform, pursued only under duress, and never truly completed.

For decades, Japan appeared to have cracked a secret formula.

How else could a nation sport a 250% debt-to-GDP ratio and still sleep at night?

The answer, unromantically, was that the Bank of Japan kept the printing press humming and interest rates pinned to the floor. For so long as rates remained near zero, the government could issue bonds indefinitely, the yen stayed stable, and voters got to enjoy both strong social spending and fairly low taxes, compared to the U.S. and Western European countries.

But in January 2026, this system hit its limit. And that limit announced itself with the 40-year Japanese government bond yield piercing 4% for the first time since its 2007 debut, a level not seen for any maturity of Japan’s sovereign debt in more than three decades. The catalyst: Takaichi’s promise to abolish the 8% consumption tax on food for two years and unlock a ¥122.3 trillion budget to finance everything from military spending to semiconductors and AI while essentially cutting revenue.

In Japan, the rise in interest rates is not a sign of a “return to normal”: it mainly highlights a system that does not know how to cope with positive real interest rates. Today’s higher yields reflect neither a growth boom nor renewed confidence, but rather the forced adjustment of a slightly more persistent inflation premium in an ultra-constrained environment. However, with public debt hovering around 250% of GDP, every sustained rise in yields brings the country closer to the sustainability threshold; beyond a certain threshold, the cost of financing becomes unstable and makes the very idea of a long cycle of monetary tightening illusory.

Investors are now demanding clearer medium‑term fiscal anchors from Takaichi’s government: how will pre‑election stimulus and tax cuts be reconciled with an ageing society, rising social spending and already‑elevated debt levels?​

The episode is also pressuring the BoJ to refine its communication around yield curve control and rate normalisation, as markets increasingly price policy shifts ahead of official guidance when fiscal signals turn more expansionary.​

The Bank of Japan’s Dilemma: Damned If You Do, Doomed If You Don’t

Here is where the comedy [or tragedy] deepens. The Bank of Japan finds itself trapped in a vice that neither rate hikes nor continued easing can escape.

For years, the BoJ’s Quantitative and Qualitative Easing (QQE), initiated in 2013, suppressed rates artificially and enabled the government to finance deficits at near-zero cost. As of end-2024, the BoJ held 46.3% of total government debt, over ¥560 trillion, making it the world’s largest holder of sovereign bonds relative to GDP.

This balance sheet dominance, while stabilising markets, has created what scholars call “fiscal dominance”: the central bank has subordinated monetary policy to the government’s financing needs, raising questions about central bank independence and inflation-fighting credibility.

In late 2024 and early 2025, the BoJ began hiking rates cautiously, raising its policy rate to 0.75%, a three-decade high. Yet even this modest tightening exposed a brutal reality. Higher rates increase the government’s debt-servicing burden at exactly the moment when revenues are stagnant and spending is climbing. St. Louis Federal Reserve analysis1 shows that the government’s consolidated balance sheet (combining the BoJ and the Treasury) holds substantial foreign-currency assets, valued at 56% of GDP, that suffer losses if the yen appreciates. For 30 years, Japan’s central bank was the world’s printing press. Now that role has become a trap.

• A tightening cycle that strengthens the yen erodes asset values and worsens the government’s fiscal position.

• Conversely, if the BoJ stays accommodative to spare the fiscal authority pain, inflation expectations may unanchored and the yen weakens, importing inflation while leaving rates artificially low and inviting yet more government borrowing.

“Fiscal dominance,” in plain English, describes an economic scenario where fiscal policy (“the power of the purse”) holds sway over monetary policy (“the power of the printing press”). Meaning, the central bank risk to no longer operate independently. It must choose between its inflation target and the government’s solvency.

The BoJ’s balance sheet is so large and so exposed to interest rate risk that even a gradual normalisation threatens losses that would flow back to a government already straining to service debt.​ Japan can always meet its yen‑denominated obligations by creating more currency, but not without avoiding the loss of real value that comes from higher inflation and persistently negative real interest rates. In that circonstances, the BoJ may ultimately welcome, a weaker yen, since currency depreciation is the adjustment that best preserves a functioning JGB market while allowing real debt to be eroded over time.

When Grandma, the Market and the Campaign Bus All Want the Same Yen

Rising debt service is slowly choking Japan’s welfare state just as aging costs surge, and an election‑driven tax cut risks increase.

Japan’s social security bill is projected to jump from roughly ¥35 trillion today to about ¥190 trillion by 2040, yet higher interest payments are already squeezing welfare budgets, local services and investment in education and infrastructure for younger generations. Each extra yen of yield is a yen diverted from hospitals and regions to bondholders, and Takaichi’s planned food‑tax cut brings that arithmetic forward by years.

Her 8 February snap election locks those giveaways in as campaign promises just as markets are making clear that unfunded tax cuts and large deficits are no longer free, with long‑term yields and debt‑service costs jumping in response. The result is a rising clash between political pledges and market discipline, in which the prime minister will soon have to choose between keeping voters happy and keeping Japan’s finances credible.

The Bank of Japan’s extraordinary balance sheet, QE, and zero rates did not create Japan’s debt; they deferred its due date. Now that due date is arriving, not as a crisis of confidence, but as a crisis of arithmetic. Bond auctions are failing. Yields are surging to levels not seen in a generation. Social programs are being starved.

When the printer runs out of ink, the blank page is not a message: it is a demand. Japan’s bond market has issued that demand. The question is whether Tokyo listens before the cost of delay becomes truly unbearable.

1

YiLi Chien and Ashley H. Stewart, “Japan’s Consolidated Balance Sheet and Challenges for Monetary Policy,” St. Louis Fed On the Economy, Oct. 24, 2024.

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Robin J Brooks

Japan's Yen Debasement

The Bank of Japan hiked its policy rate this week and yet the Yen tumbled. At first glance, that might seem puzzling, but really there is no puzzle. Japan’s longer-term interest rates - which are what drive the Yen - are much too low given massive public debt. As long as that remains true, the Yen will continue its debasement cycle…

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4 months ago · 38 likes · 5 comments · Robin J Brooks

France’s 2026 budget crisis now centres on Sébastien Lecornu’s choice to use Article 49.3 to push through a modestly deficit‑cutting budget while financial markets watch whether the deficit is credibly kept at, or below, 5% of GDP. The outcome of this week’s censure vote, hinging on a divided centre‑right, will decide both the survival of the government and the credibility of France’s fiscal path in the eyes of international investors.​

Slow‑burn budget crisis reaches a climax

France’s long‑running budgetary tensions are reaching a make‑or‑break moment as the 2026 finance bill comes to a head in the National Assembly. The government has repeatedly failed to secure stable majorities for medium‑term consolidation, and the 2026 text is seen as a test of whether Paris can still produce a coherent fiscal strategy within the EU’s revamped rules.​

At stake is not only the deficit figure for next year but also the message sent to markets about France’s capacity to control a debt ratio already well above 110% of GDP and a deficit which has hovered above 5% of GDP since 2023–2024. Central to the current showdown is the promise, reiterated by Lecornu, to keep the 2026 deficit at or just under 5% of GDP, after an estimated 5.4–5.5% in 2025, a threshold that the Bank of France and other observers now explicitly treat as a “danger zone” marker for market confidence.​

On 18–19 January 2026, Prime Minister Sébastien Lecornu confirmed that he would once again resort to article 49.3 of the Constitution to impose the 2026 budget without a standard vote, breaking a promise he made in October to refrain from using this special power. Article 49.3 allows the government to “engage its responsibility” on a finance bill, which is then deemed adopted unless an absolute majority of deputies (289 out of 577) vote a motion of censure within a narrow time frame.​ Lecornu will first activate 49.3 on the taxation component and then, within days, on the spending component, with each use automatically triggering a censure vote; a final censure test is expected after the text’s return from the Senate in February. Far‑right deputies from the Rassemblement National and the radical left of La France Insoumise have already announced that they will file and support censure motions, joined by Greens and Communists, but the Socialists, having negotiated concessions, signal they will not vote to bring the government down.​

In this fragmented chamber, the three parties of the minority governing coalition intend to stand together against censure, shifting the decisive weight to the 42 deputies of the centre‑right Les Républicains (LR). LR is internally divided, but its leaders have publicly suggested that most of the group is reluctant to plunge France into a domestic political crisis amid wider international and Atlantic tensions, a stance that leads much of the French media and many analysts to expect that Lecornu will survive the first censure vote later this week.​

The compromise budget: social concessions and targeted taxation

To secure Socialist abstention and neutralise a blocking minority on the centre‑left, Lecornu has assembled a package of social and tax measures that re‑balances the 2026 budget while keeping the headline deficit target intact. Key concessions include the generalisation of “one euro meals” at university restaurants for all students, a long‑standing Socialist demand that responds to rising student poverty, and the creation of additional teaching posts in priority sectors of the education system.​

Lecornu has also dropped plans to freeze income tax brackets, a measure that would have effectively raised taxes through “bracket creep” and was politically sensitive for lower and middle‑income households. To finance these new expenditures and a planned increase in defence spending, the government will extend an €8 billion “one‑off” surtax on large companies that was originally presented as temporary, thereby breaking an earlier promise to let this levy lapse after 2025.​

Taken together, these measures tilt the budget’s composition somewhat to the left, more targeted social spending and progressive taxation, without altering the headline goal of bringing the deficit down to around 4.9–5% of GDP in 2026. The political calculation is that modest redistribution at the margin, plus visible support for students and public services, will be easier to defend than deeper, across‑the‑board cuts that might provoke broader social unrest.​

Financial markets and the 5% threshold

For investors, the 2026 budget is less about the exact composition of spending and more about whether France can demonstrate that the deficit is on a credible downward path from 5.4–5.5% in 2025 toward, and eventually below, the 5% line that has acquired symbolic importance. The Bank of France governor has explicitly warned that a deficit above 5% of GDP in 2026 would place France “at risk” with international lenders, arguing that 4.8% would have been preferable and that 5% should be treated as a hard ceiling.​ Markets are already pricing political and fiscal uncertainty into French sovereign yields, which have hovered around 3.5% for ten‑year bonds, with spreads over German Bunds reflecting concerns about slow consolidation and volatile politics. Analysts note that every twist in the budget saga, from missed deadlines in late 2025 to last‑minute concessions in January 2026, has been accompanied by episodes of spread widening, signalling that investors see French debt as riskier whenever policy paralysis looms.​

In this context, financial markets are less focused on the technical use of article 49.3, which is a known constitutional tool, and more on whether the government emerges from the censure sequence with a functioning majority and a clear commitment to keep the deficit below the 5% danger zone. French PM stated “the credibility of France’s signature depends a lot on the credibility of giving our word on 5%”. If the budget passes and early execution data suggest that concessions to the Socialists and new defence outlays are matched by sufficient revenues from the extended big‑business surtax and other measures, the current risk premium could stabilise or even narrow.​

After signs on Monday that Lecornu would invoke article 49.3, the spread between French 10‑year bonds and German Bunds tightened to around 65 basis points, the lowest since July, before closing near 66 basis points. Even so, investors now face the prospect of a larger‑than‑planned deficit, as the government has confirmed it is targeting a 5%‑of‑GDP shortfall in 2026 instead of the 4.7% envisaged in October’s draft budget. Yet investor appetite remains strong: France’s latest bond sale raised €10 billion on orders more than ten times that amount (src: Bloomberg), underscoring that markets still have confidence in the country even as its fiscal position edges toward what the central bank governor has warned could be a “danger zone.”

The immediate political drama masks a deeper, structural issue: France’s ability to align its social model, spending priorities, and tax base with the constraints of an ageing population, the green and digital transitions, and EU fiscal rules. “It’s now up to the nation’s representatives to be responsible,” Lecornu said. “Do we go back into a crisis scenario after all these efforts at compromise, or do we escape this difficult period we’ve been stuck in since September?”. Still, repeated recourse to 49.3 to pass budgets underscores the fragility of parliamentary coalitions and raises questions about the medium‑term predictability of French fiscal policy.​

In sum, the “big crunch” censure vote expected this Thursday or Friday is about far more than the survival of one government: it is a test of whether France can still reconcile political fragmentation, social demands and EU‑level fiscal discipline without losing the confidence of the financial markets it depends on to roll over a vast stock of public debt.​​

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In France, inflation eased to 0.7% year-on-year, while Germany recorded a 2% increase, below market expectations of 2.2%. The figures follow similar signs of moderation in Italy (1.2%) and point to a broader disinflation as the euro area enters 2026.

With inflation now close to the ECB’s 2% target, policymakers have kept interest rates unchanged since June and signalled that borrowing costs are likely to remain stable for an extended period.

Markets increasingly see the current policy stance as the new equilibrium rather than a prelude to further easing.

Still, the improving inflation outlook contrasts with a more fragile economic backdrop, particularly in France, where political impasse left the country without a fully approved budget heading into the new year, adding uncertainty to the growth outlook even as price pressures fade. Meanwhile, price pressure continues to be sticky in others European countries like in Spain (3.0%), where inflation has been at or above 3% for four months now.

Though, this alleviation of inflation pressures is contrasted. Indeed, inflation for services remains high at 3.4%, steered by labor-intensive sectors and strong wage growth from contracts negotiated last year.

This dynamic presents a dilemma for the ECB:

• they cannot aggressively cut rates with services inflation on the rise,

• but doing nothing risks holding back growth in a region already facing significant economic divergence.

As we move into 2026, this unique economic landscape will test the credibility of the Eurozone’s monetary policy and could spiral into stagflation if energy prices rebound.

Is there a risk for stagflation?

Stagflation is an unusual economic phenomenon where three negative conditions occur simultaneously:

1. stagnant economic growth,

2. high unemployment, and

3. rising inflation.

A paradoxical situation where prices keep climbing even as the economy struggles.

With inflation mostly down due largely to energy costs falling, the question is worth asking. Energy costs could rebound amid a colder-than-expected late winter in Europe and rising geopolitical risks. Tensions have intensified in the Middle East following renewed unrest in Iran and escalating U.S. pressure, while relations between Washington and Moscow have further deteriorated after recent maritime incidents in the North Atlantic and actions targeting Russia-aligned oil flows. Together, these factors could reintroduce a geopolitical risk premium into energy markets and increase its prices. According to Bloomberg, “other factors that could pull inflation away from the target include the still-unfolding impact of US tariffs, the strong euro and fiscal expansion in Germany”.

And with weak growth expectation, (Germany Ifo Business Climate Index : 87.6 vs. revised 88, forecasts 88.2) - “Companies are more pessimistic about the first half of 2026. The year is ending without any sense of optimism”, Ifo President Clemens Fuest said - the room for economic stimulation is getting narrower. Additionally, the expectations component of the Ifo survey, which measures firms’ outlook for the next six months, also declined (from 90.5 vs. 89.7) and lagged forecasts. That means firms are less optimistic about future demand and economic conditions than they were previously. PMI’s numbers for the euro area also hedge toward this narrative.

The eurozone unemployment rate edged down to 6.3% in November 2025 from 6.4% in October, slightly beating market forecasts and marking the lowest reading since April. This improvement suggests the labor market remains resilient despite weakening growth momentum, with the unemployment rate still well below its long-term average of 8.9%.

However, the aggregate figure masks significant divergence across member states. While Spain, Italy, and Greece continue to record falling jobless numbers, both Germany and France have experienced rising unemployment since 2023, with this trend intensifying through 2025. Germany’s unemployment rate stood at 3.8% in October 2025, up from 3.4% a year earlier, with the OECD projecting it will reach 3.6% by Q4 2025 before moderating to 3.5% by Q4 2026. France’s unemployment rate climbed to 7.7% in Q3 2025 from 7.6% in Q2, and is forecast to remain elevated at 7.6-7.7% through 2026.

The employment situation thus presents a mixed picture: headline eurozone unemployment remains near historic lows, but the deterioration in Europe’s two largest economies, combined with pessimistic business expectations, suggests the labor market’s resilience may be weakening. This creates an asymmetric risk where aggregate statistics appear healthy while core economies face a growing slowdown, complicating the ECB’s assessment of labor market tightness and wage pressure dynamics.

This being said, Europe is not in stagflation, though analysts are agreeing on the fact 2026 will be inflationary, and carry a “tail risk” of stagflation. Some economies, like France and Germany may need to watch closely this probability, as their low growth expectation coupled with, a probable inflationary recovery coming from resurgence of energy costs, may plunge them in this scenario.

Far from being un-optimistic, several structural factors (Germany fiscal transformation, steady private consumption) and monetary policy response flexibility give the euro area tools and strength to navigate this challenging environment. Additionally, the ECB has revised wage growth projections upward, suggesting labor cost pressures remain stronger than anticipated.

So, with growth gradually recovering toward potential as fiscal stimulus takes effect, inflation continuing its descent toward target as energy base effects fade, and unemployment stabilising or declining modestly as labor market resilience persists, this “tail risk” of stagflation will just stay a risk.

Bloomberg

TradingEconomics

Nordea - Euro-area flash inflation ending 2025 at target

ECB - Data Portal

Eurostat

For two centuries, the Monroe Doctrine was the United States’ most quietly persistent ideology. It rarely appeared in campaign slogans, never needed merchandising, and did not require rallies. It simply was: a background rule of hemispheric order stating that the Americas were not an arena for foreign powers, and, by extension, that Washington retained a special right to intervene, that echos the extraordinary military operation in Venezuela (culminating in the seizure of alleged head of state Nicolás Maduro and his transfer to New York to face U.S. courts) in the early hours of 3rd January 2026.

What has changed under Trumpism is not the doctrine itself, but its style, visibility, and brutality. MAGA is not a break from American imperial logic; it is its domestication. The Monroe Doctrine has come home, stripped of diplomatic euphemisms and rebranded as political instinct. Only this time, the logic is less about keeping out European powers than about asserting American primacy across the Western Hemisphere, underpinned by a decidedly Make America Great Again (MAGA) geopolitical ethos.

The New Monroe Doctrine: ‘Don-Roe’ or ‘Trump Corollary’

At a press event following the operation, Trump explicitly rebranded this assertive posture as a modern successor to the historic Monroe Doctrine, dubbing it the “Don-roe Doctrine.”

The Monroe Doctrine is a geopolitical doctrine articulated in 1823 by U.S. President James Monroe, asserting that the Western Hemisphere constituted a distinct sphere of influence reserved for the United States and closed to further European intervention. While initially framed as a defensive political principle, it gradually evolved into a structural instrument of power projection. Its concrete application emerged in the late 19th century, notably during the 1895 Venezuelan crisis, and was decisively reinforced by the Roosevelt Corollary in 1904, which legitimised U.S. intervention to preserve financial stability and political order in Latin America.

While Trump has yet to articulate a formal doctrine, the Don-roe Doctrine point to a more assertive reading of U.S. influence in the Western Hemisphere. His comments mark a shift from diplomatic cautions in favour of direct intervention where Washington perceives threats to its security. The move echoes the recent barring of Thierry Breton, the former EU commissioner, from US territory, a reminder that this assertive posture is not confined to adversaries, but extends to allies when political or strategic lines are crossed.

Moreover, for decades prior to Trump’s second term, U.S. foreign policy in Latin America, despite its interventionist heritage, nominally centred on democratic consolidation and free trade. The Trump administration has inverted this entirely, replacing soft power initiatives with military buildups and economic coercion. In place of aid programs that, however paternalistically, promoted institution-building, Trump has deployed tariffs against Brazil (50% in an effort to pressure the judiciary to release former president Jair Bolsonaro) and Colombia (25%, imposed when Gustavo Petro resisted extrajudicial deportations).

The arrest of Venezuela’s Nicolás Maduro by the Trump administration marks a decisive escalation in Washington’s hemisphere-first posture. Framed domestically as a strike against narco-terrorism, the operation signals a broader reassertion of U.S. primacy in Latin America. Venezuela possesses the world’s largest proven crude reserves, estimated at 303 billion barrels, dwarfing Saudi Arabia’s 267 billion. That Trump seized on this distinction within hours of Maduro’s capture speaks to hierarchy of priorities.

“We’re going to have our very large United States oil companies, the biggest anywhere in the world, go in, spend billions of dollars, fix the badly broken infrastructure and start making money for the country”, Trump declared at Mar-a-Lago.

He further asserted that American companies, specifically Chevron, which currently holds the only U.S. operating license, would

“rebuild the oil infrastructure, which will cost billions of dollars. It will be paid for by the oil companies directly. They will be reimbursed for what they’re doing.”

Yet this reconstruction is set to last longer as the Venezuelan’s oil infrastructure are old and at an advanced state of dilapidation.

This shift carries material implications for markets. Latin-American sovereign risk premia are likely to rise as investors reassess the durability of political sovereignty in the region. Energy markets face renewed geopolitical risk, particularly around Venezuelan oil assets and future US corporate involvement. Meanwhile, the episode reinforces a global trend toward unilateralism, weakening multilateral norms and increasing the likelihood of geopolitical shocks feeding directly into asset prices.

A Shift in Macro / Political Risk Pricing

If a sitting head of state can be forcibly removed under a blend of criminal indictment and national security justification, sovereign immunity becomes contingent rather than absolute. This introduces a new risk factor: alignment risk vis-à-vis US strategic priorities

The immediate market consequence is likely to be:

• wider sovereign spreads for politically non-aligned Latin American issuers

• higher risk premia on local-currency debt, reflecting capital flight risk

• greater volatility in FX markets, especially where central bank credibility is weak

Empirically, evidence shows us that a high geopolitical uncertainty is not only a political issue. It has mesurable macro-financial consequences, for sovereign risk in particular:

• A broad range of research finds that geopolitical crises tend to widen sovereign credit default swap (CDS) spreads, especially in emerging and frontier markets. Sovereign spreads can jump substantially, often by more in emerging economies than in advanced economies, within weeks of major geopolitical shocks, reflecting heightened risk premia and investor aversion. Like it happens in Venezuela during the 2019 political crisis, when CDS spreads spiked sharply following the contested presidential transition, or in Argentina amid repeated debt renegotiation episodes, where emerging-market investors demanded higher yields to compensate for perceived political and alignment risk.

IMF - Geopolitical Risk: Implications for asset prices and financial stability - April, 2025 / VIDEO - IMF - Geopolitical Risk: Implications for asset prices and financial stability - April, 2025

• Additional macro research highlight how “uncertainty shocks” in the region, political or economic, translate into tighter external financing conditions, wider local sovereign spreads (e.g., EMBI spreads widening by 30–50 basis points), and sharper currency depreciations against the U.S. dollar over the following quarters.

Andres‑Escayola, E., Molina, L., Pérez, J. J., & Vidal, E. (2025). How economic policy uncertainty spreads across borders: The case of Latin America (Documentos de Trabajo No. 2549). Banco de España.

Paradoxically, unilateral displays of power can strengthen the U.S. dollar in the very short term, while potentially weakening its institutional foundations over the longer run:

• In classic “risk-off” moments, the U.S. dollar and U.S. Treasury assets have historically benefited from safe-haven flows, as global investors seek liquidity and stability.

• However, recent market behaviour has challenged this dynamic. During the market turmoil tied to trade tensions and policy unpredictability, in Apris 2025, Treasury yields rose sharply and the dollar experienced notable weakness, suggesting that the traditional safe-haven status is under strain. Financial Times - US Treasuries sell-off deepens as ‘safe haven’ status challenged

• Global investors have shown signs of watermarking this shift: surveys of institutional investors indicate growing skepticism about the long-term sustainability of U.S. fiscal policy and confidence in the dollar’s reserve role, with a majority expecting some form of partial de-dollarisation over the next decade.

  CFA Institute. (2024). The dollar’s “exorbitant privilege”: 2024 Global survey report. CFA Institute.

At the macro level, this creates a slow-burn erosion rather than a sudden collapse:

• The dollar remains dominant, comprising around 60 % of global FX reserves, but its share has gradually declined over decades, and alternative currencies are gaining modest traction in trade and settlement.

• External pressures including geopolitical realignments, elevated risk premia in emerging markets, and strategic diversification by central banks point toward a gradual rebalancing of the international monetary system. J.P. Morgan Global Research (2025, July 1). De‑dollarization: Is the US dollar losing its dominance?

In sum, if geopolitical risk is increasingly priced into sovereign risk premia and currency markets, and if confidence in U.S. policy credibility wanes, the implications are wide-ranging, from higher borrowing costs for emerging markets, to greater FX volatility, to a reshaped hierarchy of safe-haven assets and reserve currencies in global portfolios. The result is a slow-burn erosion of U.S dollar dominance rather than a sudden collapse. A world where the dollar remains dominant, but less trusted, more politicised and, potentially, increasingly weaponised.

Energy Markets: Resource Geopolitics Returns

Venezuela’s oil reserves, very arguably the largest globally, depending on the different sources, sit at the heart of this episode. Trump’s remarks about “rebuilding” Venezuela and reopening its energy sector to US firms underscore a return to resource-centric geopolitics, where regime change and asset access are implicitly linked.

For energy markets, three dynamics matter:

1. Short-term volatility: Any disruption to Venezuelan output or export routes adds risk to an already fragile oil balance, particularly in a world where spare capacity is politically concentrated. Though global spare capacity sits unevenly across producers, markets remain sensitive to shifts in perceived future availability, especially for heavy crude grades historically destined for U.S. Gulf Coast refiners.

2. Long-term investment uncertainty: While US companies may gain preferential access under a compliant regime, the precedent of coercive intervention raises questions about contract durability, expropriation risk and political reversals. U.S. companies like Chevron (already exporting under special waivers at ~140-160 thousand bpd) could, theoretically, be given preferential access or allow partial recovery of arbitration awards for expropriated assets. Massive capital expenditures, potentially $100 billion to $200 billion over years to rehabilitate production, are widely cited as necessary before output approaches historical levels.

3. Opec+ and great-power response: Russia and China, both with historical exposure to Venezuelan assets, are unlikely to view the episode as isolated. Retaliatory positioning elsewhere (Middle East, Africa, shipping lanes) cannot be ruled out, feeding into a structurally higher geopolitical risk premium for oil. This backdrop is compounded by Tehran’s internal challenges; Iran, with its own large reserves (∼210 billion barrels) and under popular strain from protests, would view aggressive U.S. engagement in Caracas as destabilising to its own regional posture.

But does the U.S. really need Venezuelan’s oil ?

As Secretary of State Marco Rubio bluntly stated

“We don’t need Venezuela’s oil. We have plenty of oil in the United States. What we’re not going to allow is for the oil industry in Venezuela to be controlled by adversaries of the United States,” he replied, naming Russia, China and Iran.

For what it looks like, dominance, and particularly geographic dominance seems to be more important here for the U.S.. At face value, the statement is economically accurate. The United States is one of the world’s largest oil producers, structurally less dependent on foreign crude than at any point in recent decades. Energy security, in the narrow sense of physical supply, is therefore not the binding constraint. What is at stake instead is geographic dominance and strategic denial. For Washington, Venezuela’s oil matters less as an input and more as a geopolitical asset. Allowing adversarial powers to control, finance, or structure the development of one of the world’s largest proven reserves would amount to conceding long-term influence over trade flows, energy pricing dynamics, and regional political alignment in the Western Hemisphere. In that sense, the issue is not barrels, but who controls optionality, future supply, infrastructure, and alignment.

This logic fits squarely within a broader pattern of U.S. strategic behaviour:

• Resource denial to rivals,

• Control of critical geography, and

• Prevention of hostile spheres of influence close to U.S. borders.

The narrative echoes recent U.S. rhetoric regarding Greenland, where economic justifications (rare earths, shipping routes, energy potential) coexist with a deeper strategic concern: preventing rival powers from establishing a durable foothold in territories deemed essential to long-term security architecture. In both cases, the underlying doctrine is not mercantilism, but pre-emptive dominance.

In that light, Venezuela is less an energy story than a Monroe-style geopolitical signal, updated for a multipolar world. The U.S. may not need Venezuelan oil to fuel its economy, but it is unwilling to allow that oil, and the leverage it confers, to strengthen competitors in an era where control over resources, chokepoints, and influence networks increasingly defines global power.

What is Don‑roe Doctrine? Trump rebrands the Monroe Doctrine after Nicolás Maduro is captured. The Economic Times (2026)

President Trump’s Latin America Policy: Short‑Term Gains, Long‑Term Risks (2025). Center for Strategic and International Studies

Venezuela’s oil is at the heart of Trump’s ambitions. Le Monde (January 4, 2026)

Spain and five Latin American countries reject U.S. attack on Venezuela in joint communiqué. Euronews (2026)

Paying over $100 billion to rebuild Venezuela’s oil industry won’t be the biggest obstacle facing U.S. oil companies. MarketWatch (2026)

The capture of Maduro represents not an aberration but a statement of principle: unilateral assertion of American power, justified by self-interested framing of national security, executed through military force without legal authorisation, and designed to ensure American corporate control of critical resources. This is imperialism not as historical accident or ideological justification for hegemony, but as explicit policy doctrine.

For Latin America, the precedent is gloomy. If the United States can unilaterally intervene to remove a sitting president, seize control of a nation’s resources, and establish indefinite political authority without Security Council approval or regional consent, then no state in the hemisphere possesses genuine sovereignty. For Europe and other American allies, the operation signals a shift in U.S. strategic priorities: the Western Hemisphere is not a partnership but a possession.

And for the international order itself, Trump’s action signals the acceleration of its decomposition. Without enforcement mechanisms, without shared commitment to restraint, and with a superpower openly asserting the right to violate foundational principles when strategic interest dictates, the architecture built in 1945 faces not modification but obsolescence.

The “Donroe Doctrine” is, in essence, the return of the law of the jungle dressed in the language of national interest. That it occurs openly, without apology, marks not the strength of American power but the exhaustion of the institutional frameworks that once constrained its exercise.

UN News

Chatham House

The Nation

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