The Bond Market Strikes Back

I hope you are enjoying the final days of summer.

Our family spent the past few weeks travelling through Asia, and we had a wonderful time. From what we saw in Vietnam and Hong Kong, the region is booming. In Hong Kong, however, the enthusiasm appears to have spilled into speculation. Posters displaying four-digit stock tickers were everywhere, while seemingly every taxi driver was monitoring the market between traffic lights. When we asked people about the companies they were trading, many knew surprisingly little about the actual businesses. They knew the ticker symbol—and, apparently, that was enough. Fundamental analysis has rarely been so efficient.

Four weeks ago, I wrote about the growing contest between governments and markets: Governments vs. Markets: Who’s Really in Charge?. Since then, policymakers have continued trying to remind markets who supposedly runs the show.

As I write this, the Japanese yen has rallied sharply amid signs of government intervention. The bigger development, however, has occurred in the U.S. bond market, where the Treasury, led by Scott Bessent, recently stepped in. Governments may not be able to control markets permanently, but that has never stopped them from trying.

Yield-Curve Control

The U.S. Treasury yield curve sounds complicated, but it is simply a menu of interest rates. It shows how much the U.S. government must pay to borrow money for three months, two years, ten years or even thirty years.

This matters well beyond government finance. Treasury yields help determine the price of mortgages, corporate loans, and many other financial assets. When Treasury yields move, they have a habit of rearranging the financial furniture.

The government’s challenge is that investor demand is not equally strong at every maturity. There is generally more demand for shorter-term bonds than for thirty-year bonds. That makes sense: lending money for two years is one thing; lending it for thirty years is closer to a long-term relationship—and investors usually want to be compensated accordingly.

Long-dated bonds are also more sensitive to changes in interest rates. If investors become worried about inflation, government borrowing or fiscal policy, thirty-year bond prices can fall quickly, and their yields can rise sharply.

So, what can policymakers do when the bond market becomes unruly? They can attempt to influence the shape of the yield curve by adjusting either demand or supply.

Influence demand: The Treasury can buy back bonds of a particular maturity. Buying thirty-year bonds creates additional demand, pushing their prices higher and their yields lower. This was the approach taken by Scott Bessent two weeks ago.

Influence supply: The Treasury can also change the types of bonds it issues. When investors demand particularly high yields on longer-term debt, the government can borrow more through shorter-term Treasury bills and notes instead. In recent years, the Treasury has leaned heavily on shorter maturities, including the area around two years.

Put simply, the thirty-year yield is the interest rate investors demand before lending money to the U.S. government for three decades. Thirty years is a long time. Before making that commitment, investors would like some assurance that inflation will not quietly eat their lunch—and then charge them for dessert.

Druckenmiller Speaks Out

Former Treasury Secretary Janet Yellen was criticized for not issuing more long-dated bonds when interest rates were much lower. The argument was straightforward: if the government could have locked in cheap financing for thirty years, why borrow short and leave itself exposed to higher rates later?

It is the governmental equivalent of declining a low-rate, thirty-year mortgage and choosing to renew every couple of years instead. That strategy looks clever—right up until it doesn’t.

In late August, famed investor Stanley Druckenmiller, who once mentored Scott Bessent, criticized the Treasury’s recent approach in a Wall Street Journal opinion piece. His concern was not merely that the Treasury was pushing yields lower. It was the message this sent. Artificially low borrowing costs may reduce the pressure on Washington to get its fiscal house in order.

As Druckenmiller put it:

“Every basis point of artificial yield suppression is a subsidy to procrastination.”

A basis point is one-hundredth of a percentage point. It is tiny on paper, but when applied to trillions of dollars of debt, these tiny numbers develop very large personalities.

The Market Reacts

When signs of Treasury intervention appeared, markets responded immediately. Long-term bond yields dropped, the U.S. dollar weakened and gold, other precious metals and Bitcoin rallied.

Why did all these markets move at once?

Bonds: The Treasury’s purchases created additional demand for long-dated bonds. More demand pushed prices higher and yields lower, which was the point of the exercise.

The U.S. dollar: Currencies are influenced partly by interest rates. Higher yields can attract foreign capital because investors earn more for holding assets in that currency. When U.S. yields declined, the dollar became slightly less attractive and weakened against other currencies.

Gold and other stores of value: If investors believe the Treasury is interfering with the bond market, they may become less enthusiastic about holding U.S. government debt. Foreign reserve managers could respond by directing more money toward gold and other alternatives.

There is also the question of real interest rates, which simply means the interest rate earned after accounting for inflation. If a bond yields 4% but inflation is 3%, the investor’s real return is only 1%. If policymakers push bond yields lower while inflation remains elevated, that after-inflation return, shrinks.

Gold pays no interest, which is normally one of its drawbacks. But when bonds pay very little after inflation, gold’s lack of income becomes less embarrassing. It is a bit like being the only person at a party without a job—until everyone else gets laid off.

Portfolio Implications

The initial market moves did not last long. Within a week, long-term bond yields had climbed again. The market was effectively testing whether policymakers had both the determination and the firepower to keep yields down.

This contest is far from over. Governments can push markets around for a while, but markets have deeper pockets, longer memories and no election calendar.

With that in mind, we continue to favour three broad investment themes:

Short the U.S. dollar: The rest of the world may become less willing to finance America by continually buying U.S. Treasury bonds. Less demand for Treasuries can also mean less demand for dollars. If U.S. equities weaken, foreign investors could reduce their American holdings, creating an additional source of pressure on the currency.

Long emerging markets: A weaker U.S. dollar often improves the environment for emerging markets. Many countries and companies borrow in dollars, so a falling dollar can make those debts easier to service. It can also encourage international capital to move into emerging-market currencies, bonds and equities. After spending years as the neglected section of the investment menu, emerging markets may finally be worth ordering.

Long precious metals: Countries that save more than they spend must invest those savings somewhere. If they become less comfortable holding U.S. government debt, they may increasingly turn to gold as an alternative store of value. Gold does not issue earnings guidance, hold conference calls, or require faith in fiscal discipline. These qualities are becoming more appealing.

As I wrote four weeks ago, there will probably come a time when government bonds become compelling investments. High yields can eventually provide attractive income, along with the potential for capital gains if interest rates later decline.

For now, however, it still appears a little early to load up.

The meal may be cooking, and it may eventually be delicious—but it is not ready to come out of the oven. Bond investors should resist the temptation to eat the soufflé while it is still batter.