Keep one eye on U.S. bond yields
Global financial markets are enjoying a period of relative calm, with investors seemingly unperturbed by the unpredictability of U.S. President Donald Trump’s second term. The spectre of a trade war between the United States and China, which once loomed large, has, for now, receded, with optimism about deregulation and tax cuts replacing those concerns.
As stewards of capital, however, investors must look beyond current optimism to anticipate potential disruptions.
Could the bond market represent the faulty lighthouse into which equity markets crash?
The bond market appears to be signalling developments that could challenge the current tranquillity. Rising yields, a looming U.S. debt ceiling, and unconventional Treasury manoeuvres are arguably converging in ways that that warrant some attention.
The U.S. Treasury market, where 10-year yields are hovering near 4.5 per cent appears stable, but a closer examination reveals pressures that suggest yields could be higher. The U.S. Treasury’s recent actions, coupled with the Federal Reserve’s cautious stance, point to a subtle shift in monetary policy dynamics.
Some analysts argue that the Treasury is effectively assuming a role traditionally reserved for the Federal Reserve. A heavy reliance by Treasury on short-dated T-bills to finance the federal deficit has injected substantial liquidity into the financial system since early 2024.
Of course, it’s not all Treasury. The liquidity boost stems from two mechanisms. First, the Federal Reserve’s reduction of its Reverse Repo Facility (RRP) is estimated to have released approximately US$2 trillion into the system. It’s arguably Quantitative Easing (QE) without being called that.
Second, it’s estimated the Treasury has contributed an additional US$4 trillion by skewing its debt issuance toward short-dated bills rather than longer-dated bonds. The claim by some analysts is the shift is stimulatory because it reduces the “dollar duration” of the debt (a measure of interest rate risk exposure), as bills require less balance sheet capacity than bonds.
Banks, which favour these shorter-dated securities, effectively monetise the federal deficit by purchasing them, amplifying liquidity and allowing the Treasury Secretary Scott Bessent to continue ‘managing’ the rising debt levels.
Trump’s actions contradict his words
Despite President Donald Trump’s claims of reducing the U.S. federal deficit, the data tells a different story. For the first five months of the 2025 fiscal year to February (the U.S. fiscal year runs from 1 October to 30 September), the U.S. budget deficit reached a record US$1.147 trillion, with February alone showing a US$307 billion deficit, up four per cent from the previous year. This increase occurred despite efforts by the Trump administration’s Department of Government Efficiency (DOGE) to cut spending.
Trump’s tax proposals, including extending the 2017 Tax Cuts and Jobs Act (TCJA) and introducing new cuts such as zero taxes on tips or overtime pay, are projected to add significantly to the deficit. Estimates suggest these policies could increase the deficit by US$4.5-US$5.1 trillion over 10 years. While Trump has proposed spending cuts, such as a US$163 billion reduction in non-defence discretionary spending, these are dwarfed by mandatory spending (e.g., Social Security, Medicare) and interest payments, which continue to drive deficit growth.
Additionally, during Trump’s first term, the deficit grew significantly, with the national debt increasing by about US$7.8 trillion, partly due to the 2017 tax cuts and COVID-19 relief spending.
Implications
The implications of this liquidity surge are twofold. In the short term, it acts as a tailwind for global financial markets. Approximately 80 per cent of global lending is now collateral-backed, and the increased issuance of Treasury bills expands the pool of high-quality collateral, supporting lending and market activity.
You’d expect this dynamic to sustain market optimism for the time being, particularly as the Treasury’s bill-heavy issuance keeps yields on longer-dated bonds in check (keeping them from going up amid a significant supply of bonds).
The longer-term outlook, however, might be less benign because the bond market is showing signs of strain, with term premia – the additional yield investors demand for holding longer-dated bonds – trending higher.
Quite rightly, some analysts suggest this rise reflects growing investor concerns about duration risk, particularly as the Treasury’s monetisation of the deficit reduces the supply of long-dated bonds available to the private sector.
The rub
Higher term premia could eventually push yields upward, with significant adverse consequences. Rising yields depress bond prices, eroding the value of fixed-income portfolios. Simultaneously, liquidity experts suggest rising bond volatility can adversely impact global liquidity, as it influences the “haircut” applied to collateral values, which in turn affects the collateral multiplier. Higher volatility leads to larger haircuts, reducing the amount of liquidity generated through collateralised lending. This can have the effect of withdrawing liquidity from the market in the short term and potentially triggering a sell-off in risk assets like equities.
The bond market’s stability is thus a critical variable to monitor, as it could determine whether the current stock market rally continues or falters.
The Treasury’s reliance on short-dated bills also raises questions about sustainability. By prioritising bills over bonds, Treasury avoids flooding the market with long-dated securities that could drive yields higher. However, this approach effectively monetises the deficit, a process that historically invites scrutiny from “bond vigilantes”– investors who demand higher yields to compensate for perceived fiscal profligacy.
If the bond vigilante narrative gains traction, it could push 10-year yields well above the 4.5 per cent threshold that the Trump administration reportedly aims to maintain, disrupting the delicate balance of liquidity and yield management.
Complicating this picture are external factors, such as the U.S. debt ceiling, Moody’s recent downgrade of the U.S. credit rating to Aa1, and the Treasury’s planned US$50 billion in bond buybacks by early August. The debt ceiling, a perennial source of political brinkmanship, could reignite market volatility if negotiations falter. Moody’s downgrade, while not immediately disruptive, highlights nascent, if not growing, concern about the sustainability of U.S. debt levels. The buybacks, intended to manage debt maturities, could further tighten the supply of long-dated bonds, reinforcing the upward pressure on term premia.
Meanwhile, tariffs may have adopted a backing role in the current act, but they haven’t left the stage. Tariffs could still disrupt trade flows and stoke inflation, prompting a reassessment of bond yields. Fiscal policy changes, such as tax cuts or infrastructure spending, could widen the deficit, necessitating even greater debt issuance. These variables, combined with the Treasury’s liquidity manoeuvres, create a complex and potentially volatile environment.
While a surge in liquidity might justify current market optimism, the bond market might just be flashing warning signs that investors should be mindful of.
The Treasury’s bill-heavy financing strategy has provided a short-term boost, but it risks fuelling higher yields and volatility in the longer term. Rising term premia, a potential bond vigilante resurgence, and external pressures like the debt ceiling and tariffs all threaten to destabilise the market. Investors would be wise to keep a close eye on bond yields, as they may hold the key to whether the current calm persists or gives way to resurgent turbulence.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
