The bond market, though often overshadowed by the stock market’s flashy headlines, is a far more profound indicator of economic vitality and a stealthy driver of government policy. Unlike equities, which capture short-term exuberance or panic, bonds reflect the deeper currents of investor confidence, inflation expectations, and fiscal sustainability. Last week, it was the bond market’s unsettling movements—not the stock market’s volatility—that likely rattled the administration.
Zooming out, the bond market’s broader trajectory suggests a growing risk of higher government yields—a shift with sweeping implications. Sovereign yields in a country’s own currency, like the U.S. dollar, are shaped by three core forces: trend growth (hovering around 1.5% to 2%), inflation expectations (markets currently peg long-term inflation at roughly 2% to 2.5%), and the term premium (the extra yield investors demand for holding a 10-year note versus rolling over short-term securities.)
Together, these components define the theoretical “fair value” yield for a 10-year U.S. Treasury note, which some analysts estimate ranges between 4.6% and 6.8%. Today’s 10-year Treasury yield of around 4.50% sits below this fair-value range, suggesting yields may climb.
Convexity and Carry: Bondholders’ Hidden Advantages
Yet, bonds aren’t a one-way bet against rising yields. Two technical factors—convexity and carry—currently tilt the risk-reward profile in favor of bondholders, marking a shift from the pitfalls of 2022.
Convexity measures how a bond’s price sensitivity (duration) changes with interest rates. Positive convexity creates an asymmetry: Using today’s levels, if yields drop by 100 basis points, bond prices will rise more than they’d fall if yields rise by the same amount. For example, a 10-year yield at 4.50% might gain 11% in price if yields fall to 3.50% but lose only 3% if yields rise to 5.50%. This lopsided payoff makes bonds a compelling hedge against economic slowdowns or rate cuts.
Carry is the income from coupon payments—say, 4.5% annually on a 10-year Treasury note. It acts as a buffer: even if prices dip due to rising yields, the coupon offsets losses over time. In a holding period of a year, carry can soften the blow of moderate yield increases.
Contrast this with 2022, when bondholders bet on falling yields amid raging inflation—a misstep that led to steep losses as the Fed hiked rates aggressively. Today, with yields higher and the Fed’s next move uncertain, convexity and carry offer a lifeline. Blindly replaying 2022’s playbook would ignore these evolving dynamics.
A demand-driven recession—think slowing growth with tame inflation—could trigger such a drop if the Fed slashes rates to stimulate the economy. This asymmetry underscores why bonds remain attractive, especially as recession risks linger.
Risk-Off Disconnect: Why Yields Aren’t Falling
But the market’s recent behavior complicates this picture. Historically, a risk-off environment—where investors flee stocks for safe havens like Treasuries—drives yields. Yet, despite the recent equity selloff, U.S. 10-year yields have been climbing. This defiance hints at a “negative tint” on government debt, likely rooted in tariffs, fiscal unease or inflation scars from 2021–2022. Investors may fear that trillion-dollar deficits and persistent price pressures outweigh bonds’ safe-haven appeal.
The 10-year swap spread—the gap between U.S. Treasury yields and swap rates—offers a clue. This spread reflects credit and liquidity risks tied to Treasuries. It surged to 60 basis points last week, then dipped to 50 basis points after the administration paused tariffs (except on China) for 90 days. But it’s since climbed back to 55 basis points, signaling lingering distrust. A widening spread suggests that even in risk-off mode, Treasuries aren’t the sanctuary they once were.
A Path to New 2025 Highs
Market sentiment now leans toward a U.S. 10-year yield trading back above the January 2025 peak of 4.80%. Several forces fuel this, including Fed policy: A hawkish stance, wary of inflation’s return, limits rate-cut bets, keeping yields elevated. Supply pressure: The Treasury’s borrowing spree—projected at $2 trillion annually—floods the market and lifts yields. Global demand: Foreign buyers, once a bulwark for Treasuries, are diversifying reserves, reducing demand.
A move above 4.80% would raise borrowing costs further, testing policymakers’ reliance on cheap debt. While the bond market’s long-term trajectory points to higher yields—potentially a headache for policymakers—the current set up for bondholders may be a modest headwind, but convexity and carry keep the downside manageable.
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