Long bonds are selling off for a new reason

The ten-year Treasury yield has broken through 4.55 per cent, a sixteen-year high, and the reason has changed. In 2022 and early 2023 bond yields rose because markets expected the Federal Reserve to keep lifting rates. The latest sell-off in long-dated Treasuries comes from a flood of new government debt meeting private buyers who care about price.

Policy no longer explains it

The shape of the move gives it away. Two-year yields, which follow expectations for the Fed, have barely risen since the summer, while ten- and thirty-year yields have climbed sharply, so the curve has become less inverted from the long end. Most of the increase has come in real yields rather than in the compensation investors demand for inflation, which points to a higher price for time and not to fresh fears about prices. Estimates of the term premium, the extra return for holding a long bond instead of rolling short ones, have risen from the deeply negative levels of the quantitative-easing years.

Last week's Fed meeting added to the pressure without changing the diagnosis. Officials held rates at 5.25 to 5.50 per cent and trimmed the cuts they expect next year, which lifted the front end a little. The long end moved further, and it had been moving before the meeting. A market driven by policy would have done the reverse.

Too much paper, too few buyers

The federal deficit has swollen to $2 trillion, and the Fed keeps shrinking its bond portfolio through quantitative tightening. Supply of long-dated debt now far outstrips demand, and the imbalance looks permanent. Foreign central banks and domestic commercial banks, buyers who traditionally paid little attention to price, have stepped back. Yields have had to rise to tempt hedge funds and asset allocators instead. The bond vigilantes are pricing duration risk, with monetary policy a secondary concern.

The supply arrives on a timetable. In August the Treasury raised the size of its longer-dated auctions for the first time since 2021 and said it expected to borrow about $1 trillion in the July-to-September quarter alone. The Fed, meanwhile, lets up to $60 billion of Treasuries a month mature without reinvesting the proceeds, so private investors must absorb that debt as well. Each auction has become a test of how much extra yield buyers demand to take down the new paper.

The deficit itself has an awkward composition. Tax receipts have fallen from last year's peak, spending on social security and health programmes keeps growing with an ageing population, and interest costs are rising as cheap debt issued in 2020 and 2021 rolls into today's rates. Higher yields therefore feed on themselves: every rise in borrowing costs enlarges the deficit that has to be financed through the next round of auctions.

Who has left the market

The departed buyers have their reasons. China's holdings of Treasuries have fallen to their lowest in more than a decade, and Japanese investors, facing hedging costs that wipe out the yield advantage, have little incentive to add. American banks, stung by the bond losses that sank Silicon Valley Bank in March, are shrinking their securities portfolios. The marginal buyer is now a pension fund, an insurer or a leveraged hedge fund, and each needs a higher yield before committing.

The Bank of Japan's gradual loosening of its yield-curve control adds a further pull. In July it said it would treat the 0.5 per cent cap on ten-year Japanese yields as a reference rather than a hard limit, and domestic yields have crept up since. Every basis point that Japanese investors can earn at home without currency risk is a reason to keep money out of Treasuries.

The vigilantes' record

The vigilantes, a label coined in the 1980s for investors who punish fiscal laxity by selling, have won before. In 1993 the Clinton administration shaped its deficit-reduction plan partly to calm the bond market, and last autumn gilt investors forced Britain to abandon its unfunded tax cuts within weeks. America's reserve-currency status gives it far more room than Britain had, but it does not suspend the arithmetic of supply and demand.

The losers from a supply-driven sell-off differ from those in a policy-driven one. Holders of long bonds, including insurers and the banks still carrying underwater portfolios, take the mark-to-market losses. Thirty-year mortgage rates, which price off the ten-year yield, stay above 7 per cent even if the Fed stops raising rates. Equities with long-dated cash flows, such as unprofitable technology companies, lose value as the discount rate rises, while savers able to lock in real returns above 2 per cent for a decade gain.

The case for a pause

The strongest counterargument is that supply shocks are one-off adjustments. Once yields are high enough to attract pension funds keen to lock in returns, demand could prove deep, and a slowing economy would drag yields down whatever the issuance. The Fed could also slow its balance-sheet reduction if the market struggles. Those are real risks for the bearish view, but none addresses a deficit this large with unemployment below 4 per cent, a point in the cycle when deficits normally shrink. The Treasury's next refunding announcement in early November, the results of long-dated auctions and the budget fight in Congress will show where the market finds its level.

Long bonds are now falling because of supply, and Treasury auctions will keep pushing yields higher for as long as Washington borrows at this pace. The November refunding is the next point at which the Treasury can either feed that pressure or relieve it.