Is the US bond market starting to rebel?

Episode Summary

Executive Summary: The episode debates whether global bond markets are “rebelling” against fiscal laxity, sticky inflation, and weak long-end demand. Brad argues rising U.S., Japanese, and U.K. yields reflect worsening debt, deficits, and inflation risk; Ajay counters that much of this is already priced, tariff inflation should be temporary, and yields should eventually fall as growth slows and central banks ease.

Main Topics: Are bond markets rebelling globally? (Priority: 5/5): The hosts frame recent spikes in U.S., Japanese, and U.K. long-term yields as a possible global bond-market revolt against deficits, inflation, and policy uncertainty. U.S. fiscal deterioration and debt sustainability (Priority: 5/5): Brad argues the U.S. debt-to-GDP ratio around 100% and persistent 6-7% deficits are unsustainable, especially if the current tax bill locks in large deficits for a decade. Tariffs, tax policy, and deficit arithmetic (Priority: 4/5): The discussion centers on whether tariff revenues and some tax hikes offset the cost of extending tax cuts, with Ajay saying much of the fiscal impact was already priced in. Inflation and the risk of sticky price pressures (Priority: 5/5): Brad worries tariffs and goods-price spikes could keep inflation above target, while Ajay says tariff inflation is temporary and core PCE has recently been below 2% annualized. Foreign demand for U.S. Treasuries (Priority: 4/5): The hosts debate whether shrinking foreign ownership—especially from Japan, China, and the U.K.—will weaken Treasury demand as U.S. financing needs rise. Japan’s yield normalization and spillovers (Priority: 4/5): Rising Japanese bond yields are highlighted as a new source of pressure because Japanese investors may no longer need U.S. Treasuries for yield pickup. Rates outlook and term premium (Priority: 5/5): Ajay argues high long yields largely reflect expectations that the Fed will not cut much; Brad counters that term premia, fiscal risks, and inflation uncertainty could push yields higher.

Key Arguments: Brad argues U.S. debt dynamics are worsening because debt is already around 100% of GDP and deficits of 6-7% are too large for a healthy economy. Brad says a tax bill that preserves or expands large deficits could keep debt/GDP rising for a decade and prevent stabilization. Ajay contends the fiscal outlook is not meaningfully worse than what markets expected entering the year because tax-cut extensions and tariffs were partly anticipated. Brad questions the durability of tariff revenue, noting legal challenges and uncertainty around future administrations. Ajay responds that tariffs have become embedded policy and revenues are likely to persist, as happened with the 2018 China tariffs. Brad argues inflation remains a threat because the U.S. has not been at 2% for years and tariff-driven goods inflation could push CPI to 4-4.5% in the summer. Ajay counters that tariff inflation is transitory and that core PCE has recently run below 2% annualized, supporting eventual easing. Brad warns that falling foreign demand for Treasuries—especially from Japan—combined with lower dollar recycling could pressure long yields higher. Ajay says Japanese yields, while rising, still leave U.S. Treasuries attractive on a spread basis and foreign auction demand has not yet deteriorated sharply. Ajay believes current long-end yields are near a fair level because the market expects the Fed funds rate to bottom around 3.2-3.3%, implying 10-year yields near 4.5% are reasonable. Brad emphasizes that if inflation stays sticky and fiscal discipline does not improve, term premia could keep rising and drive yields even higher.

Data Points: U.S. debt-to-GDP: 100% - Brad cites U.S. federal debt at roughly 100% of GDP and rising quickly. U.S. annual deficit: 6-7% of GDP - Brad says the U.S. has run deficits in this range for the last few years. Long-run growth assumption: 4% of GDP - Brad argues a stable deficit should not exceed expected nominal GDP growth of about 4% (2% real, 2% inflation). Potential deficit under current tax bill: 6-7% of GDP for the next decade - Brad says the bill could lock in high deficits, preventing debt stabilization. Current U.S. mortgage rates: around 7% - Used to illustrate how elevated borrowing costs remain. Japan 30-year yields: all-time highs in May - Ajay cites Japanese long-end yields as a global bond-market shock. Japan 40-year yield: over 3.5%, still over 3% - Ajay notes this as a new high for Japan and a key shift in domestic yield alternatives. U.S. 10-year vs Japan 10-year spread: almost 3% - Ajay argues this still makes U.S. Treasuries attractive relative to Japanese bonds. China holdings of U.S. debt: less than $1 trillion - Brad cites China’s reduced Treasury ownership as evidence foreign demand is waning. Largest foreign holder of U.S. debt: Japan at about $1.1 trillion - Ajay identifies Japan as the biggest foreign owner of U.S. Treasuries. Second-largest foreign holder: U.K. at about $750 billion - Ajay says the U.K. has moved into second place ahead of China. Fed funds trough expectation: 3.2-3.3% - Ajay says markets expect the Fed’s easing cycle to bottom around this level. Implied 10-year yield fair value: about 4.5% - Ajay suggests 10-year yields are consistent with a Fed funds trough near 3.2-3.3%. Tariff-related goods inflation window: a few months - Ajay argues tariff inflation will be temporary and pass through in a short period. Core PCE inflation: below 2% annualized for the last two months - Ajay uses this as evidence underlying inflation is cooling.

Pivotal Quotes: "bonds could intimidate anybody" — James Carville (quoted by Brad): Introduced to frame the power of the bond market over policymakers. "Tariff inflation is transitory." — Ajay: Ajay’s core defense that tariff-related price pressures should fade rather than embed into persistent inflation. "The way to get lower interest rates is for the economy to stumble." — Ajay: Ajay’s view that long rates will fall if growth weakens enough to force more Fed easing.

Implications: The debate suggests bond yields may stay volatile as fiscal policy, tariffs, and foreign demand evolve. For investors, the key risk is persistent term-premium pressure if deficits and inflation remain sticky; the key offset is eventual slowing growth and Fed easing.