Why Treasuries Are 'Risky' Again

Episode Summary

Executive Summary: Tracy Alloway and Joe Weisenthal speak with economist Carolyn Fluger about why Treasury yields have surged, how markets form a perceived Fed reaction function, and why bonds have become more stock-like and riskier. The discussion links inflation credibility, Fed communication, bond-stock correlations, and geopolitical power, arguing that higher yields reflect both changing policy expectations and a rising risk premium.

Main Topics: Perceived Fed reaction function: Fluger explains how markets infer the Fed’s response to inflation and output, and why that perception affects monetary transmission and market pricing. Learning from actions vs. communication: The conversation emphasizes that markets changed their view of the Fed mainly after the Fed actually began hiking rates, not just through forward guidance. Treasury bonds becoming riskier: Fluger argues that Treasuries have shifted from safe, negative-correlated assets to more stock-like instruments with higher risk premia. Drivers of higher bond yields: Rising yields are framed as reflecting both inflation expectations and, importantly, a higher compensation demanded for bond risk. Historical regime shifts in bond markets: The episode contrasts the 1980s inflation era, the post-2000 safe-bond era, and the recent re-risking of bonds amid supply shocks and inflation uncertainty. Geopolitics and financial power: The discussion broadens to how bond-market depth, borrowing costs, military power, and hegemonic transitions may be linked over long horizons.

Key Arguments: Markets form a perceived policy reaction function by observing how the Fed responds to inflation and output; this expectation influences rates even before the Fed meets. The most effective way to move that perceived reaction function is through action: markets learned the Fed was serious about inflation only after rate hikes began in 2022. Treasuries were unusually safe after 2000, but recent years have seen them become more risky and more positively correlated with stocks, especially during inflationary shocks. A meaningful share of the post-2020 rise in long yields can be explained by higher bond risk premia, not just by inflation. Stable long-run inflation expectations do not mean everything is calm; volatility can still rise through uncertainty, and nominal and inflation-linked bonds can decouple. A more gradual, credible central-bank response can help keep bonds bond-like by reducing the chance that inflation shocks force a destabilizing regime shift. Bond-market safety and geopolitical power are historically intertwined; lower borrowing costs can reinforce military and financial dominance over time.

Data Points: 30-year U.S. Treasury yield: 5.592% - Discussed as having hit the highest level since 2002 at the time of recording. Year of highest 30-year yield prior to current move: 2002 - The hosts note the 30-year yield is at its highest since 2002. Inflation surprise in May 2021: Almost 0.5% surprise; about 6% annualized - Used to show how little yields reacted when the perceived Fed reaction function was extremely flat. Fed rate hike after Jackson Hole: One hike - Mentioned as part of the backdrop for ongoing yield increases. Survey horizon for Blue Chip forecasts: Up to six quarters out - Used in Fluger’s methodology for estimating the market-perceived policy reaction function. Perceived inflation response in markets: From about 0 to about 1 - Describes the rise in perceived Fed responsiveness to inflation from early 2022 to late 2023. U.S. 10-year yield in the 1980s: 11.5% - Cited to contrast with modern yield levels and historical bond risk regimes. Share of decline in 10-year yields since mid-1980s explained by safer Treasuries: Roughly one-quarter - Back-of-the-envelope estimate from Fluger’s research. Chinese 30-year bond yield: 2% - Mentioned in passing when comparing U.S. and Chinese long-term bond yields. Spread between U.S. and Chinese 30-year bonds: Over 350 basis points - Used by the hosts to illustrate the dramatic divergence in yields.

Pivotal Quotes: "Bond's got to be more bond-like." — Joe Weisenthal: His succinct takeaway from the interview, capturing the idea that Treasuries should regain hedging characteristics. "We call that the Learning from Actions channel." — Carolyn Fluger: Her term for the fact that markets updated their view of the Fed mainly after actual rate hikes, not just rhetoric. "The price of our liberty." — Carolyn Fluger: Quoting Alexander Hamilton to underscore the historical link between sovereign borrowing capacity and military power.

Implications: Listeners should expect yields to stay sensitive to both Fed credibility and Treasury risk premia. For markets, the key question is not just inflation, but whether bonds remain reliable hedges—or continue behaving more like equities.