I started working at a stockbroker, Grieveson Grant, before Big Bang (1986) in London. At that time some brokers focused on gilts, others on equities, and others, such as Grievesons, did both. But there was no doubt that the gilts desk was the more important of the two in size and revenue, and where the senior partner came from.
From Big Bang onwards, equities eclipsed government bonds, reflecting Reaganomics/Thatcherism and then QE after the Global Financial Crisis. It was only in 2020 when governments chose to borrow in response to the COVID lockdowns that attention turned back to how they were going to finance their borrowing. For over five years now my key metric to watch has been the 10-year U.S. bond yield.
And so it came to pass
A year ago I commented that, while bond yields had risen, I expected U.S. 10-year bond yields to reach new post Global Financial Crisis highs. My reasoning was threefold: the extreme low levels term premia had reached, the amount of Government financing required, especially in the light of the 6 to 7% primary deficits in the U.S., and the prospects of much higher inflation in the longer term as a result of current profligacy.
I suggested, however, that the inability of the financial system to survive much higher bond yields would cap rising yields. Over the past 30 years successive Fed. Chairmen have made it plain that avoiding financial crises is high on their agendas. Higher bond yields increase the cost of servicing debt for both public and private borrowers. And crises happen when somebody is unable to service or refinance their debt.
Under Janet Yellen, the authorities’ response has been to use short-term non-coupon-bearing T-bills to finance the U.S. government’s debt. 22% of all U.S. debt is now in the form of T-bills with less than 12 months duration. This suppresses the supply of bonds, and therefore lowers bond yields. The hard evidence for this is contained in the 50bp spread between Agency mortgages and equivalent T bonds. There has also been over the last year about a one year drop in the average duration of U.S. government debt. That suggests that without the reliance on short-term financing, 10-year T-bonds would today be trading at a yield of above 5%.
At this point I cannot resist saying ‘and so it came to pass’. We have seen U.S. 10-year bonds reach nearly 5% and mainstream commentators are commenting on short-term funding and term premia, subjects normally too arcane for them.
Fundamentals have not changed
But market conditions evolve continually and the new Treasury Secretary, Scott Bessent, will likely adopt different policies. The second half of this article looks at what that might mean for bond markets.
The fundamentals have not changed: Government finances remain precarious, with U.S. needing to re-finance around $8 trillion in 2025, some 30% of its total issued marketable debt. Term premiums (i.e., the extra yield required to hold longer term debt) have risen, but remain low relative to history, and inflation seems to be settling at a higher number than the 2% most central banks view as their target.
In my view, unless politicians suddenly discover a backbone, there is no option but a return to QE. In the short-term this may well suppress bond yields but in the longer-term we are off to the magic money-tree of much higher inflation.
But the politics is now different
The question is how, with a new Administration and a new Treasury Secretary in Scott Bessent, the politics has changed. Trump both does and doesn’t care about financing. He has already put a moratorium on large areas of funding. His gamble is that he can generate enough internal growth to replace the tax revenue he will lose from tax cuts and increasing protectionism.
Janet Yellen’s solution to the problem was to reduce supply of bonds by relying more on short-term funding. However, Bessent has already said he will stop this practice, which implies either less borrowing or that projected bond issuance will be higher than expected.
The question for markets is how this plays out: will the bond vigilantes demand a higher yield to compensate for fiscal profligacy and higher inflation expectations, or will the new Administration manage to convince them they have things under control.
Will a return to QE flood the market with new demand for bonds, and drive yields down as after the Global Financial Crisis? Or might Powell and Bessent find different ways of suppressing yields?
Against this is the fall in Chinese bond yields. If Japan is a pattern, then the yield differential should lead to a stronger US$ vs the yuan. This would in fact help China exit the economic hole it finds itself in, although so far the authorities have shown little sign of allowing the yuan to depreciate. If they continue to hold the line, would the impact of a stronger dollar on US exports again lead the Federal Reserve to search a way of capping yields?
Where will bond yields go
Our friends at CrossBorder Capital lean towards the former, and expect U.S. 10 year yields to rise towards 5.5%. In their view yields should in fact be close to this level already, but have been suppressed by Yellen’s restriction of issuance. If they are right, it is hard to believe that equity valuations can ignore a move of this level.
In the short to medium term, my view is more ambivalent. I doubt the U.S. financial system could survive 5.5% yields: there is already plenty of evidence of fragility in corporate debt markets, everywhere from repos through to private equity. While I expect bond yields to go higher, perhaps much higher, in the long term, in the shorter term I expect U.S. 10-year yields to stay below 5%.
Further out, the yield curve may steepen as longer dated bonds begin to factor in higher inflation in the longer-term and central banks nudge down interest rates against a slowing economy. I note that the U.K. break-even inflation levels have crept up to 3.3% at ten, twenty, and thirty year tenors.
In short, bonds have returned to the place they were over 40 years ago, at the centre of the investors’ universe. Ignore them at your peril. If CrossBorder Capital’s view is right, equity valuations look too high. If they are capped in the short-term by a return to QE, watch out for inflation.
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