Election jitters push up long-term rates

Ten-year Treasury yields have climbed above 4.20 per cent as the US presidential election nears, and almost all of the rise comes from the term premium. The Adrian-Crump-Moench (ACM) measure of that premium is back in positive territory. Bond investors are worried about the public finances.

What the premium measures

A long bond's yield reflects two things: the path of short-term rates investors expect over its life, and an extra return for tying money up that long. The ACM model, maintained by economists at the Federal Reserve Bank of New York, estimates the second part by stripping out the first. For most of the decade after the financial crisis, the premium was negative, because quantitative easing, low inflation and a global hunger for safe assets meant investors were content to lock in long yields with no reward for the risk.

That era ended with the inflation of 2021 and 2022. The premium turned positive briefly in the autumn of 2023, when the ten-year yield touched 5 per cent after the Treasury increased the size of its auctions and Fitch stripped America of its top credit rating. It fell back as inflation eased and markets priced Fed cuts. Its return now, while the Fed is actually cutting, is what makes this move notable.

Deficits either way

Whether Donald Trump or Kamala Harris wins, federal deficits will stay unusually large by historical standards, and the Treasury will have to sell trillions of dollars of new debt. Bond buyers are no longer willing to hold thirty-year paper without a decent premium for fiscal disorder and the risk of inflation. The bond vigilantes want to be paid.

The fiscal arithmetic is grim whoever occupies the White House. Federal debt held by the public is now roughly the size of annual GDP, and net interest payments exceed what the government spends on defence. Much of the tax cuts passed in 2017 expire at the end of next year, and both candidates have pledged to extend large parts of them without saying how the cost would be covered. Mr Trump's plans for further tax cuts and higher tariffs add inflation risk on top of the borrowing; Ms Harris's spending proposals would widen the deficit too, if by less on most independent estimates.

Why the timing is now

Markets have also shifted their view of who will win. As betting markets and polls moved towards Mr Trump in October, investors put on trades associated with his victory: a stronger dollar, higher yields and a steeper curve. His proposals combine larger deficits with tariffs that would lift import prices, a mix that raises both the supply of bonds and the risk of inflation over their lifetime. Bond investors are charging for that combination in advance.

The buyers of Treasuries have changed too. The Fed is still shrinking its holdings rather than adding to them. Foreign central banks, once dependable buyers, are no longer increasing their holdings. That leaves more of the supply to price-sensitive investors such as pension funds, insurers, hedge funds and households, who demand a higher return before they will take on duration. The Treasury has also leaned on short-term bills to finance the deficit over the past year, which has held down the supply of long bonds; any shift back towards longer maturities after the election would add to the pressure at the long end.

Vigilantes have struck before

The phrase bond vigilantes dates from the 1980s, and the bond market has disciplined governments before. In 1994 long yields rose sharply as the Fed tightened and investors fretted about inflation, inflicting heavy losses across global bond markets. The early Clinton administration shaped its deficit reduction plans in part to reassure bondholders. In September 2022 Britain's mini-budget of unfunded tax cuts sent gilt yields soaring and forced the Bank of England to intervene; the prime minister was gone within weeks.

America is not Britain. The dollar's role as the world's reserve currency and the depth of the Treasury market give Washington far more room for error. The lesson of 2022 is subtler: markets can tolerate high debt for years, and then reprice abruptly when fiscal plans look careless.

The case for calm

Some caution is in order. Term premium estimates are model-based and can be revised substantially as new data arrive. Part of the rise in yields since September reflects strong economic data, above all September's payroll report, which pushed back expectations for Fed cuts. By the standards of the 1980s and 1990s, when term premiums of several percentage points were normal, today's premium is tiny.

That last point cuts both ways. If the negative premiums of the 2010s were the anomaly, a return to historical norms would mean substantially higher long yields even with inflation at target. The rise so far may be a first step rather than an overreaction.

Who pays

The costs spread widely. Mortgage rates follow the ten-year yield and have risen since the Fed cut. Companies issuing long-term debt face higher coupons, and the Treasury itself pays more on every new bond, which feeds back into the deficit. Savers and pension funds buying long bonds earn more, and banks benefit from a steeper curve. For the Fed, higher long yields do part of its tightening for it, which may argue for a slower pace of cuts.

The election on 5 November, the Fed's meeting the same week and the Treasury's quarterly refunding announcement will set the tone. Weak demand at long-dated auctions would signal that the premium has further to rise. So would any sign that the next administration plans to lean on the Fed or to pair tax cuts with tariffs large enough to lift inflation expectations.

The bond market has started to charge for deficits it assumes will never close. Whoever wins, the Treasury should expect to pay more on long-dated debt through next year and probably well beyond. A Republican sweep would probably push the ten-year yield higher still in the weeks after the vote, while a divided Congress would limit the damage without reversing it.