Higher Treasury yields, weak demand, and swelling deficits—time to revisit what happens when bond vigilantes run the town.
KEY TAKEAWAYS
MY HOT TAKES
Unmasked. It’s one of my favorite terms. I use it often when I speak with the press, though it seems to go… well, unquoted. Perhaps it was overused in another era. Who knows? Regardless, the bond vigilantes have ridden back to town.
They made a brief appearance late last year in the run-up to the presidential elections. Both President Trump as well as Candiate-VP Harris offered up the cookie jar in order to curry favor from would be voters. Both–it was not just Trump that offered up plenty of fiscal stimulus.
Simultaneously the Sheriff of Yields–The Fed began loosening up on credit, after imposing martial law on rates for the better part of the two years prior. That was enough to get the 1980s bond vigilantes to take their shotguns off the mantle, mount up, and ride into town.
Perhaps a younger version of the posse first made their presence known in the 1980s, slamming bonds, causing yields to spike in protest of a rising deficit and high inflation. It was also the era when the word “stagflation” was invented.
Last fall, the US was still in the grip of inflation, and the already large deficit and swelling debt pile seemed poised to get larger. The already-bloated deficit was the result of normal growth which was thrown into overdrive resulting from the massive pandemic stimulus.
It is not clear exactly how to mathematically tie long-term bond yields to changes in total debt, though it is certainly possible to project debt based on the Federal deficit. And, in case you missed one of the key themes of the day–the deficit is growing and poised to accelerate if the so-called “Big Beautiful Bill” makes its way onto the President’s desk. So, it is safe to assume that total debt is about to expand.
Remember, the Government gets its income from taxation, and lower taxes means less money to spend. Same as your home budget. Also similar to some (NOT ALL) homes, when shortfalls appear, so do credit cards to cover them. In the case of the Government, it’s more borrowing.
So, revenue is about to go down and spending–well, Congress and DOGE are doing their best to trim that, but alas, the cuts in spending are not enough to cover the cuts in revenue. Enter–deficit increases. Now, all three major credit rating agencies will tell you that the Government may struggle (but with an extremely low probability) to pay its debts as a result of the growing deficit. If that is the case, it means that risk has increased which means that investors (or… lenders) will require higher yield to take on the increased debt. This should, in theory, warrant higher yields.
Um… in case you haven’t already noticed, yields are higher. They have been. Fed policy is the gravity that keeps the front end ( < 5-year maturity) of the yield curve anchored, but the remaining tenors are controlled by bond traders–supply and demand. Check out this chart then follow me to the close.
This chart shows 10-year (orange line) and 30-year (green line) Treasury yields. Both of those are under the control of traders. If they go higher, as they have, traders are expecting more yield. That is to say, demand is low. You got it? Demand low ➡️ higher yields. Now, if the deficit widens and the Treasury has to sell more bonds to cover the shortfall, supply increases. You got it? Supply high ➡️prices lower ➡️yields higher.
So, we have vigilantes and low demand on one side of the equation and a Treasury that is going to have to supply more on the other side. That seems like a recipe for higher yields. Yesterday, the Treasury auctioned off $16 billion in 20-year bonds. Wouldn’t you know it, demand was weak. Why? Well, the real answer is that investors felt that they deserved higher yields for lending money for the next 20 years, knowing that supply is about to ratchet up, and that supply increase will… wait for it… will put downward pressure on prices.
Why then, did stocks fall as well? There is certainly a mathematical relationship between treasury yields and theoretical, intrinsic stock values. Is that why they fell yesterday? Probably not. The weak bond auction more than likely gave traders a reason to take some profits in what was starting to become an overbought market. Like an excuse.
Now we have higher bond yields and with those higher mortgage rates, which are certainly not good for the already struggling housing market. Higher yields will also cost the borrowing Government more money in debt service. Seems like trouble is brewing.
What about the Sheriff? Can the Fed help by lowering interest rates? No, because it runs the risk of reigniting inflation which will get upward pressure from tariffs and increase demands caused by tax breaks. Actually, the Fed would secretly like to see rates a bit more restrictive to keep goods demand in check. Not wanting to upset anyone with rate hiking, the Sheriff is happy to let the bond vigilantes do what needs to get done.
YESTERDAY’S MARKETS
Stocks got slammed yesterday, closing in the red as traders rushed for the doors in response to a weak Treasury Note auction. The Republican-led “Big Beautiful Bill” marched forward igniting swelling deficit fears. 10-year note yields closed just below 5.6% while 30-year bonds closed above 5%, a level briefly enjoyed in ‘23, but not effectively there since 2007 prior to that.
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