The Return of the Bond Market Vigilantes

James Carville, Bill Clinton's political advisor, famously said that if there was reincarnation, he would like to return as the bond market. Then he would be able to force governments to do whatever he wanted them to do about the economy. By this, he meant that the bond markets set the level of long-term government bond yields that are the most relevant for an economy's performance. If they set them high enough, they can force governments to make economic policy U-turns.

Against the background of the parlous state of US and Japanese public finances, there are already clear signs suggesting that next year we will see the return of the bond market vigilantes in a way that can roil world financial markets. The first is the strange behavior over the past year in US long-term bond yields. The second is the recent ructions in the Japanese bond market in response to the irresponsible budget policy being pursued by Sanae Takaichi, Japan's new prime minister.

Start with the odd behavior of the US bond market. Generally, when the Federal Reserve cuts its interest rates to stimulate the economy, long-term bond yields are supposed to decline. Yet, this has clearly not happened in the Fed's latest interest rate cutting cycle. Since September 2024, the Fed has reduced its lending rate by 175 basis points from a range of 5.25–5.50 percent to one of 3.50–3.75 percent. Yet, over the same period, far from declining, the 10-year Treasury bond yield has increased by almost half a percentage point from 3.7 percent to its current level of 4.15 percent.

This odd performance might be indicating that the US government bond market has doubts about the government's ability to bring down inflation on a sustainable basis. One factor that might be fueling those doubts is the strong likelihood that Trump's budget policy will keep the budget deficit at around seven percent of GDP for as far as the eye can see. In turn, according to Goldman Sachs, that could raise the country's public debt to GDP ratio to an Italian and Greek-like level of 130 percent by 2034. Another factor that could be keeping long-term interest rates high is Trump's relentless undermining of the Fed's monetary policy independence. That could be raising questions in the markets about the possibility that Trump will try to inflate his way out from under the public debt mountain.

Let us turn to Japan, where the bond market vigilantes presently appear to be more in evidence than in the United States. Since March 2024, when the Bank of Japan ended its yield control policy, long-term Japanese government bond yields have approximately doubled to their highest levels in the past 25 years. The 10-year government bond yield rose from around 0.75 percent in March 2024 to its present level of over 2 percent. Meanwhile, over the same period, the 30-year bond yield has increased from 1.8 percent to its present level of 3.45 percent.

The principal factor underlying the recent blowout in Japanese government bond yields is the highly expansionary budget policy stance of the new Japanese prime minister. At a time when Japan's public debt to GDP ratio is already at 230 percent and when Japan's inflation rate exceeds the Bank of Japan's two percent inflation target, Ms. Takaichi has introduced Japan's largest budget policy stimulus since the COVID-19 pandemic. She has also abandoned the government's earlier objective of striving for a primary budget surplus to put the public finances on a more sustainable path.

Over the past few years, investors have borrowed heavily at low interest rates in Japanese yen to finance their purchases of higher-yielding US dollar assets. The danger now is that these carry trades could unwind in response to the narrowing of the long-term interest rate differential between the United States and Japan. That would seem to be the last thing that the United States needs at a time when it has to finance a government budget deficit that is running at a rate of $2 trillion a year and when it also needs to roll over a large amount of maturing government debt.

All of this clouds next year's US economic outlook. Higher government bond yields could lead to higher mortgage, car loan, and other key borrowing rates. That could constitute a major headwind to the economic recovery. At the same time, higher long-term rates could be the trigger that bursts the apparent Artificial Intelligence and stock market bubbles. Barring an unlikely US and Japanese budget policy U-turn, we should brace ourselves for rough economic sledding next year in the US and world financial markets.

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