Why Government Bonds Are Risky Again
Over the past five years, most of the surge in Treasury yields has not been driven by inflation expectations, but rather by the shift from negative to positive correlation between Treasuries and stocks, as investors demand higher risk premiums.
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Long yields reached new highs despite Federal Reserve rate cuts
Recording date: the 30-year Treasury yield stood at 5.592%, the highest since 2002. Notably, this peak came after the Fed had already begun cutting rates—raising the question whether rate cuts actually loosened financial conditions as intended, or whether long-end yields have decoupled from the Fed's actions.
Markets execute monetary policy if they correctly understand the Fed's reaction function
Carolyn Pflueger introduces ‘policy reaction function’: the market's expectation of how the Fed will adjust rates in response to inflation and employment data. If markets correctly understand this function, incoming data automatically pushes rates toward the Fed's desired direction, effectively letting markets complete the Fed's tightening or easing preemptively. But this only works when the reaction function is properly ‘understood.’
— Carolyn PfluegerInflation surges couldn't move rates because markets had frozen their expectations
In 2021, a cautionary example: despite the Fed pegging rates at zero under average inflation targeting, inflation surprised sharply higher—the May surprise annualized to 6%—yet two-year yields didn't budge. More tellingly, nearly everyone expected rates to stay at zero regardless of their own inflation forecast, showing the market had ‘frozen’ its reaction-function expectations and stopped responding to inflation data.
— Carolyn PfluegerMarkets only changed inflation expectations after watching the Fed actually raise rates
Markets learn from actions, not words. The market's perceived inflation response coefficient jumped sharply only when the Fed actually began raising in March 2022, rising from near-zero to 1 between early 2022 and end-2023. Market expectations shifted late, after the Fed moved, not beforehand based on guidance—what Pflueger calls the ‘learning from action’ channel.
— Carolyn PfluegerTreasury bonds switch between risky and safe-haven status depending on stock correlation
Treasuries were not always safe assets. In the 1970s–1990s, they were as risky as stocks—both rose and fell together, reflecting the era of bond bears and inflation risk premiums. After 2000, Treasuries became a stock hedge, moving opposite to equities. Recently, that property reversed; bonds and stocks move together again. The measure is the correlation between Treasury and stock returns.
— Carolyn PfluegerBond-market risk like the 1980s requires both a supply shock and Fed recession acceptance
For Treasuries to regain 1980s-style risk requires a perfect storm: a supply-side inflation shock like oil price spikes, or fiscal breakdown triggering out-of-control inflation expectations, combined with the Fed accepting recession to fight inflation. Over the past five years, despite high inflation, the Fed was able to raise rates gradually, unlike the 1980s forced rapid tightening that created recession.
— Carolyn PfluegerRecent Treasury yield increases come from bond-stock correlation, not inflation expectations
Research shows roughly one-quarter of the long-term yield decline from mid-1980s to the 2010s came from improved hedging properties of Treasuries; but most of the 2020–2025 yield rise can be explained by Treasuries behaving like stocks again, even as long-term inflation expectations stayed stable. Unlike the 1980s, this risk resurgence appears mainly in inflation-linked bonds (TIPS), not traditional nominal Treasuries.
— Carolyn PfluegerWhich nation dominates globally is ultimately decided by bond market expectations
Pflueger cites Hamilton's 1790 writings and Britain's deep, low-cost bond market built before the Napoleonic Wars, showing how military and financial advantage historically reinforce each other. Her models identify a critical threshold: when borrowing capacity is strong enough, market expectations become self-fulfilling—if markets deem a nation safer and offer lower borrowing costs, that expectation self-actualizes. Theoretically, hegemonic shifts could occur through market pricing alone, without war.
— Carolyn PfluegerIndex inclusion shaping China-US rate spreads shows index providers control financial hegemony
Joe closes by noting the 30-year China-US yield spread now exceeds 350 basis points, a reversal completed during the pandemic—Chinese bonds previously yielded more than Treasuries. He suggests China's yield decline began around 2018–2019, coinciding with inclusion in global bond indices, implying that index construction shapes the architecture of global financial hegemony.
— JoeIn their own words · checked verbatim
That was an inflation surprise of almost half a percent. So annualized, the surprise component was 6%. That's huge. And the two-year rate didn't move, not at all.
Carolyn Pflueger13:09
that's when in our data, we see that the perceived inflation response really picks up. It basically goes from zero to one between, say, early 2022 towards the end of 2023.
Carolyn Pflueger15:11
treasury bonds were not always safe historically. So there were periods, especially during the seventies, eighties and nineties when Treasury bonds were viewed as quite risky.
Carolyn Pflueger19:17
it really requires a perfect storm to go back to the 1980s risky bond markets. It requires the inflationary shocks.
Carolyn Pflueger23:26
Once we quantify that a little bit, and I'll call it a back of the envelope calculation, what we find is that roughly maybe a quarter of the decline between the mid-80s and 2010s in the 10-year yield was due to treasury bonds becoming better hedges.
Carolyn Pflueger28:30
But over the past five years, or let's call it 2020 through 2025, The increase in the 10-year yield was really, the majority was, you can explain with changes in bonds becoming more stock-like.
Carolyn Pflueger28:30
look, most countries that are involved in a war need bond markets and the US credit is, and I'll quote here, is the price of our liberty.
Carolyn Pflueger37:44
the yield of the Chinese 30-year bond, 2% right now. That's crazy.
Joe40:51
Figures
| 30-year Treasury yield | 5.592%, highest since 2002 | 1:01 |
| 1980s 10-year Treasury peak | 11.5% | 26:30 |
| May 2021 inflation surprise (annualized) | 6% | 13:09 |
| Perceived inflation response coefficient change | 0 to 1 (early 2022 to end-2023) | 15:11 |
| Yield decline 1980s–2010s attributable to improved hedging properties | approximately one-quarter | 28:30 |
| China's 30-year government bond yield | approximately 2% | 40:51 |
| 30-year China-US government bond spread | exceeds 350 basis points | 47:03 |
Glossary
- policy reaction function
- Market expectations of how the central bank will adjust interest rates based on inflation and employment data.
- TIPS
- US government bonds whose principal adjusts with inflation, protecting holders from inflation erosion.
- forward guidance
- Central bank's advance disclosure of future rate paths to guide market expectations.
- Ricardian equivalence
- The theory that government deficit spending is ultimately offset by equivalent private savings or tax expectations.
- bond-stock co-movement
- A measure of whether government bonds and stocks rise and fall together or move inversely, reflecting whether bonds provide safe-haven properties.
How to listen
Investors and macro researchers focused on Treasuries, the dollar system, and global capital flows, as well as those seeking empirical evidence on claims of ‘dedollarization.’
The closing discussion about fiscal deficits and Ricardian equivalence has limited information value and can be skipped.