Why Treasuries Became Risky Again

The 30-year Treasury yield was 5.592% on September 29, its highest level since 2002, after a sharp rise in recent weeks. Yields kept climbing after a Federal Reserve rate decision, prompting questions about whether financial conditions were tightening as intended. The episode’s central point is that Treasuries have become less reliable as a hedge against falling stock prices: when bonds and stocks move together, investors can lose value in both at once.

Carolyn Fluger explained that markets’ “reaction function” is the response investors expect from the Fed when inflation or economic activity changes. Her research with Michael Bauer and Adi Sundaram estimates that response using forecasters’ projections for rates, inflation, and output. If investors understand how the Fed is likely to react, they can adjust to economic news before an FOMC meeting, helping monetary policy reach financial markets. But that transmission depends on the expected response being clear.

The perceived Fed response to inflation was unusually weak in 2021: even with inflation at 5–6%, forecasters expected rates to remain near zero across a range of inflation expectations. In May 2021, an inflation surprise of almost half a percentage point—about 6% annualized—barely moved the two-year yield. After the Fed began raising rates in March 2022, initially by 25 basis points, markets gradually inferred a stronger response. By late 2023, the estimated response to inflation had risen from about zero to one, a change the researchers call “learning from actions.”

Treasuries generally moved with stocks before 2000, making them a source of risk during parts of the 1970s, 1980s, and 1990s. After 2000, they more often moved in the opposite direction and served as a hedge. That relationship has shifted again, leaving investors who hold stocks and bonds with less protection when markets fall. Stagflation is especially damaging because inflation erodes the value of nominal bonds while recession weighs on stocks. Bond volatility has also risen, and nominal and real bonds have become less correlated; before 2000, nominal 10-year Treasuries and inflation-indexed bonds were highly correlated.

Fluger’s research attributes roughly a quarter of the decline in the 10-year yield from the mid-1980s to the 2010s to improved Treasury hedging, alongside factors such as lower inflation expectations. From 2020 through 2025, bonds becoming more stock-like explain the majority of the 10-year yield increase, while long-term inflation expectations remained relatively stable. The pattern appears across U.S. maturities and other developed markets, although the bond-market sample is smaller than the stock-market cross-section and realized returns can differ from expected returns. The guest said a combination of 1980s-style supply shocks and more inertial, 2000s-style monetary policy best described bond risks in 2021–22, with inflationary shocks affecting real and nominal rates differently.

A return to the bond risks of the 1980s would likely require a “perfect storm,” such as supply or oil-price shocks, weakened fiscal credibility, and rising inflation expectations, combined with a Fed willing or forced to accept recession. Since around 2000, demand shocks and stronger monetary-policy credibility have supported more gradual policy; Fluger said a gradual response to supply shocks can help preserve Treasuries’ hedging role. She did not claim to know why inflation expectations stayed stable despite the Fed missing its inflation target for roughly five years. She also stressed that changing perceptions of Treasury safety are only one influence on yields: the natural rate and demand for scarce safe assets matter too.

The episode also connected bond-market depth with borrowing capacity and national power. The U.S. 10-year yield was below China’s until around late 2020, then moved to a spread of more than 350 basis points; the discussion cited a Chinese yield of 2% versus about 5.6% for the U.S. A model Fluger and co-author Pierre developed suggests that cheaper borrowing can compound over decades into greater productivity and military capacity. Fluger described the possibility that expectations about which country is safer could become self-fulfilling and contribute to a hegemonic transition without war as hypothetical. She also noted that U.S. industrialization efforts would cost more in dollars or resources than they would have 10 or 15 years earlier.