The new narrative – navigating the bond market storm
The bond market is currently grappling with significant turbulence, driven by a confluence of fiscal, monetary, and geopolitical factors. Investors are shying away from bonds, particularly U.S. Treasurys, as yields climb and uncertainty mounts. This article explores what’s happening in the bond market, why it’s occurring, and the implications for equity markets in both the short and long term, offering guidance for investors navigating this challenging landscape.
The bond market is experiencing a sharp rise in yields, with 30-year U.S. Treasury yields reaching 5.15 per cent intraday on 26 May, 2025, the highest since mid-2007. This surge is mirrored globally: 30-year UK gilts hit 5.60 per cent, and Japan’s 30-year bonds touched an all-time high of 3.07 per cent. The cost of insuring against a U.S. default, measured by credit default swaps (CDS), has spiked from 30 basis points at the start of 2025 to over 50 basis points. These movements reflect growing investor unease about public indebtedness, particularly in the U.S., where a weak Treasury auction a week or so ago and Moody’s downgrade of the U.S. credit rating from AAA have added to concerns about the S&P 500, which trades at more than 20 times one year forward earnings, while the CAPE Shiller Ratio (CAPE) trades at over 30 times.
Bond vigilantes are bond traders who sell or short-sell bonds to protest unsustainable fiscal policies, thereby pushing yields higher. This phenomenon isn’t limited to the U.S. In Germany, increased defence spending is straining budgets; in the UK, borrowing figures have exceeded expectations; and in Japan, long accustomed to high debt levels, rising yields suggest investor concern is becoming more acute. Inflation-protected bonds, such as U.S. Treasury Inflation-Protected Securities (TIPS), are leading the yield surge, with 30-year TIPS offering 2.7 per cent yields, suggesting markets expect monetary policy to remain restrictive amid fears of tariff-induced inflation and geopolitical tensions inspired by Trump, Putin and Jinping.
The primary catalyst for all this, however, in the U.S. is President Trump’s proposed tax-and-spending bill dubbed somewhat inanely by Trump as the “big beautiful bill”. One of its effects is to extend the 2017 Tax Cuts and Jobs Act, but it will also introduce new tax exemptions (e.g., for tips and overtime pay), and reduce Medicaid and clean-energy subsidies. These measures, combined with increased state and local tax (SALT) deductions, are expected to balloon the U.S. budget deficit, with net federal debt already at 100 per cent of Gross Domestic Product (GDP). The Congressional Budget Office (CBO) projects deficits of 6-7 per cent of GDP through 2034, potentially adding US$3-4 trillion to the debt if temporary tax cuts become permanent – a likely scenario given historical precedents. I should add the market is ignoring the bill’s reliance on “sunset clauses” to mask long-term costs, as temporary tax cuts usually persist due to political pressure from recipients.
Meanwhile, globally, Germany’s increased defence spending is a function of geopolitical tensions in Europe, and a response to Trumps insistence that Europe pay more for its own defence. The UK’s higher-than-expected borrowing and Japan’s rising yields also reflect doubts about the sustainability of their respective debts.
And back in the U.S., The Federal Reserve has pivoted somewhat hawkishly amid tariff-induced inflation risks. This, in turn, has diminished expectations for a rate cut, and understandably, bond investors feel undercompensated for the longer-term risk they adopt, when cash is yielding 4.3 per cent. And they might not be wrong. The rise in inflation-protected bond yields suggests markets anticipate more-permanently tighter monetary policy.
For equity investors, it’s worth understanding the transmission mechanisms between rising bond yields and falling stock markets.
Rising bond yields increase corporate borrowing costs, potentially squeezing profit margins and triggering equity market volatility. With equity market valuations already elevated, higher yields render markets more nervous and vulnerable to the slightest shiver. The response is a diversion of capital from equities to bonds, particularly as the risk-reward trade-off for stocks worsens. Growth sectors like emerging technology, whose cash flows we have long explained are further out on the horizon, have valuations more reliant on low discount rates, and are therefore especially vulnerable.
The emerging narrative of uncertainty surrounding Trump’s fiscal policies and their implications for global debt dynamics is exacerbating market swings, with defensive sectors like utilities likely to fare better, as we saw in markets, for example, on 26 May.
If monetary policy remains hawkish and deficits persist – the latter being likely now that the “big, beautiful bill,” eked out passage by a single vote this week – equity markets could face sustained pressure. Higher interest rates may crowd out private investment, slowing economic growth and weighing on corporate earnings. However, the impact will, of course, vary by sector: defensive and dividend-paying stocks may outperform, while growth stocks could lag. The potential for a steeper yield curve suggests that long-term borrowing costs could rise further, challenging leveraged firms. Conversely, robust economic growth, if spurred by fiscal stimulus, could support equities, though Trump’s bill is less pro-growth than his 2017 reforms, with measures like tip exemptions and higher State and Local Tax (SALT) deductions offering limited economic stimulus.
With equity valuations back near all-time highs and bond markets volatile, investors are more seriously weighing up the advantages of cash and attractive yielding asset classes such as private credit. Older investors will remember the ‘cash-is-king’ mantra during the recession we had to have in the early 1990s. Cash and its equivalents in private markets offer a safer haven for those needing liquidity and attractive returns.
At a minimum, the risk of equity corrections and bond price declines makes cash an attractive interim option.
To be fair, however, fears of Western government defaults are the more extreme version of the current narrative gripping markets and are likely overblown. Countries like the U.S. can print their currency to meet obligations, and that currency debasement is what is driving gold and Bitcoin. For some investors, these alternative assets may also hold appeal for a portion of their portfolio. The prospect of extreme fiscal mismanagement does elevate risks.
The current concern about markets highlights the need for portfolio diversification and an assessment of the appropriate balance between exposure to equities and investments in assets that aren’t exposed to public markets, such as cash, and carefully selected private credit.
The bond market’s current upheaval is being driven by Trump’s fiscal policies, global debt concerns, and a hawkish Federal Reserve. The new narrative is the U.S. bond market’s status as the ultimate risk-free asset and the benchmark for all other bond markets is now in question, and its inspiring contagion-like responses worldwide. And in yet another example of self-fulfilment, the impact of course is higher funding costs for governments.
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.
