Why Treasuries Are 'Risky' Again

The 30-year Treasury yield was 5.592% at recording time, its highest level since 2002, after climbing sharply over the preceding weeks. Yields kept rising even after a Federal Reserve rate hike, raising the question of whether markets were tightening financial conditions as intended or whether the Fed’s communication and credibility were in doubt. The discussion also raised large deficits and AI-related borrowing, but emphasized that changing perceptions of Treasury risk are only part of the explanation for higher yields.

Carolyn Fluger’s research measures the market’s perceived Fed reaction function: how investors expect policy to respond to economic conditions. The estimates use forecasts from as many as 30 to 50 forecasters, including monthly Blue Chip forecasts, extending up to six quarters ahead. In 2021, the perceived response to inflation was extremely flat: even when inflation reached 5% to 6%, forecasters expected the federal funds rate to stay near zero. In May 2021, an inflation surprise of almost 0.5 percentage points—about 6% annualized—produced no movement in the two-year yield. The perceived response rose from about zero to one between early 2022 and late 2023, after the Fed began raising rates in March 2022. The researchers describe this change as “learning from actions.”

Treasuries were risky in the 1970s, 1980s and 1990s, when bonds moved more like stocks. After 2000, their relationship with stocks turned negative, making bonds a more effective portfolio hedge. That protection has weakened recently: bonds and stocks have moved together, increasing Treasury risk and putting upward pressure on yields and downward pressure on prices. This shift has also affected inflation-indexed bonds. The recent increase in risk is still smaller than the rise seen in the 1980s, and it reflects greater inflation-related volatility rather than a comparable surge in long-term inflation expectations, which have remained relatively stable over the past five to seven years.

Inflation was a major source of bond risk before 2000, while demand-driven recessions after 2000 tended to reduce inflation and benefit nominal bonds. A return to 1980s-style conditions would, in the guest’s view, require a “perfect storm,” such as inflationary supply shocks or weakened fiscal credibility that raises inflation expectations, together with a Fed willing or forced to accept a recession. Fluger estimates that Treasuries becoming better hedges accounted for roughly one-quarter of the 10-year yield decline from the mid-1980s to the 2010s. Their becoming more stock-like explains the majority of the 10-year yield increase from 2020 through 2025.

The guest cautioned that changing perceptions of Treasury risk are not the only drivers of yields; shifts in the natural rate and demand for scarce safe assets may also matter. The research does not examine changes in the Treasury buyer base. It includes the BAAA–AAA spread as a measure of financial conditions, but that variable’s estimated effect was small and did not materially change the other results. The speakers also discussed research suggesting investors may demand lower bond prices, and therefore higher yields, when required to hold more bonds or when bonds become more volatile. Bond risks appear, to a first order, to be priced in relation to stocks because of bond-stock co-movement, though investors may also care about bond-specific exposure.

The discussion connected borrowing capacity with national power, recalling Alexander Hamilton’s 1790 argument that U.S. credit was “the price of our liberty.” In a model with co-author Pierre Red, deeper borrowing capacity can reinforce military advantage; depending on initial conditions, a lead may compound or the system may converge toward another hegemony. The speakers treated a change in which markets consider one country safer than another as a hypothetical transition, not a claim that it has necessarily happened. They suggested benchmark index providers could influence future financial hegemony, noting that Chinese bond yields’ longer-term decline began around late 2018 or 2019, when Chinese bonds entered indices. U.S. 10-year yields were below Chinese 10-year yields until late 2020, and the speakers said the spread is now over 350 basis points.