Bond Vigilantes, Saddle Up!

I’ve been working in investment management, bonds in particular, for 24 years. Fears about the US budget deficit were always a thing, and the bond vigilantes were always a boogeyman lurking in the shadows, waiting to pounce. But thanks to low inflation and the dollar’s reserve currency status, they never really did.

Sure, we had selloffs. But for most of my career, when Treasury yields went down it was because investors were scared and bidding up bonds as safe havens. When yields went up, it was usually because growth was strong and investors were redeploying capital into equities and other riskier assets. Yes, the US ran big deficits, but America was special. Budget problems were something other countries had to worry about. We would innovate and grow our way out of ours. 

This time feels different.

We still have reserve currency status, but inflation no longer has the lid on it that it did for the post-2000 period prior to COVID. CPI is running at 3.4%, PCE inflation remains above the Fed’s 2% target, and the Iran war has introduced additional supply-side price pressure. Negotiations have stalled, sanctions are tightening, traffic through the Strait of Hormuz has been disrupted, and Iran has threatened retaliation if the pressure increases. No evident offramp there.

The immediate geopolitical transmission mechanism is energy. Diesel is particularly important because it touches almost everything that gets grown, manufactured, or moved. US diesel refining margins recently reached record levels as Middle Eastern and Russian supply disruptions hit an already tight market. Higher diesel prices eventually find their way into freight, agriculture, construction, and consumer goods. Not surprisingly, the conversation at the Fed has moved from how quickly to cut rates to whether rates may need to go up again.

All of this is happening against a fiscal backdrop that was already uncomfortable. CBO projects a roughly $1.9 trillion federal deficit this year, while net interest expense is expected to reach about $1 trillion, approaching one-fifth of federal revenues. Those interest costs grow as debt accumulates and older debt is refinanced at higher average rates.

Treasury can play around the edges. We just saw it increase buybacks of long-dated bonds to improve liquidity in the long end. Treasury can also tilt more of its borrowing toward bills and shorter maturity notes rather than locking in expensive 20- and 30-year financing.

But the deficit must still be funded.

If Treasury borrows less at the long end, more of the financing has to come from somewhere else. Relying heavily on bills lowers duration today but increases rollover risk tomorrow, because those securities mature in a year or less and must be refinanced repeatedly. If rates stay high while the debt continues to grow, the interest bill keeps rising quickly.

I wish I could see an easy way out. Fiscal discipline would obviously help, but given the political landscape and where federal spending goes, I have trouble seeing enough of it arriving soon enough. Faster productivity growth from technology would help enormously, but relying on an AI-driven productivity boom to solve the federal budget is not much of a fiscal plan.

For bond investors, I think the implication is a little uncomfortable. Treasuries can still provide excellent protection against recession, financial stress, and falling inflation, and we continue to think duration has an important role in a balanced portfolio. But investors should no longer assume that every bad headline is automatically good for bonds. A geopolitical shock that raises inflation, combined with persistent deficits and large refinancing needs, can hurt risk assets and Treasuries at the same time.

That makes the source of the risk more important than it used to be. Duration remains a valuable hedge against some outcomes, but it is not a hedge against fiscal arithmetic. If productivity does not improve significantly and fiscal policy does not change, the adjustment eventually must show up somewhere. Higher taxes, lower spending, higher real rates, or more inflation are the obvious candidates. None is particularly painless.