The recent fluctuations in the bond market serve as a stark reminder of its power to influence fiscal policy.
A class of investors often called “bond vigilantes,” are demonstrating their potential to shape the economic landscape, particularly regarding the proposed tax cuts and their impact on the national deficit.
The rise in long-term Treasury yields, with the 10-year yield surpassing 4.5% and the 30-year yield approaching 5%, indicates a growing concern among investors.
This surge in yields, which reflects a decrease in bond prices, suggests that the market is reacting to the potential increase in government borrowing that would result from the proposed tax cuts.
House Republicans’ current tax bill, which projects a $3.8 trillion increase in the deficit by 2034, has triggered quite a response.
The concept of “bond vigilantes,” coined by economist Ed Yardeni, refers to investors who enforce fiscal discipline by selling off government debt when they perceive policies as inflationary or fiscally irresponsible.
This action forces the government to borrow at higher interest rates, impacting its overall financial stability.
The current situation echoes past instances where the bond market has influenced policy decisions. For example, in the 1990s, President Clinton adjusted his economic agenda following market pressure.
More recently, the swift downfall of former U.K. Prime Minister Liz Truss, whose unfunded tax cuts sparked a financial crisis, highlights the significant role these investors play.
While the composition of the bond market has evolved since the 1990s, with hedge funds and wealth managers playing a more prominent role, the fundamental principle remains.
A larger deficit necessitates more government borrowing, which, in turn, increases the supply of Treasury debt. This increased supply makes existing bonds less attractive, leading to higher yields.
The administration’s argument that economic growth from lower taxes and deregulation will offset the increased deficit is met with skepticism by the bond market. The market’s reaction to the proposed tax cuts suggests a concern that these measures may exacerbate the already substantial deficit — projected to reach $1.9 trillion in the 2025 fiscal year.
The potential for a significant bond sell-off raises concerns about the government’s borrowing costs. As the deficit grows, the government must issue more debt to finance its operations.
This increased supply of debt can drive up interest rates, making it more expensive for the government to borrow. Consequently, higher interest payments can further strain the budget, creating a cycle of increasing debt.
The bond market’s reaction also highlights the delicate balance between stimulating economic growth and maintaining fiscal responsibility. While tax cuts may boost short-term growth, their long-term impact on the deficit and interest rates can have significant consequences.