Should we be concerned about a potential crash of the Treasury Market?
No, you should worry when it rallies.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
If you are a regular reader, you are probably already familiar with many of the arguments below. However, based on several conversations about interest rates with readers that I had in the last weeks and months, I still believe it’s worth to summarize my view on the most pressing questions on the bond market and its ramifications for the stock market and the economy.
TLDR Summary
Potentially rising interest rates will neither force the stock market to its knees nor will they trigger a recession. In a fiscal dominance regime, you want to be afraid of falling rates, not rising rates. Falling rates are the horseman signaling that the party is over.
Surging rates drive deficit spending and indicate strong economic growth. To the extent they become a risk for the solvency of the private sector, the government as the quasi monopolist issuer of liquidity can manipulate rates down.
If they do manipulate rates down, this will not be inflationary and therefore not be a concern for the Fed’s mandates because it will reduce deficit spending. A borrowing response from the private sector is possible, but in its magnitude very unlikely to offset the deficit reduction.
Will the government manipulate rates down should private sector borrowers crack? Yes, because the Fed has a treble mandate and needs to respond to rising unemployment that would inevitably occur in a credit crunch.
Might foreigners weaponize their $9tn Treasury holdings should the trade war escalate? Possible. But would that raise interest rates? Unlikely. In addition to their Treasuries stake, foreigners own $53tn of other US domiciled assets. Should they withdraw their withdraw capital from the US at a large scale, they will do so from all asset categories. The entire US economy will suffer from that capital drain. Incomes will fall (or grow less) and so will consumption. The capital that stays within US borders will have to rerate prices to that shock. Most likely this would mean lower interest rates and lower asset prices.
The latest rout in the bond market
After the infamous Liberation Day on April 2, 2025, US Treasuries briefly rallied, but then started a sharp sell-off. The 10-Year yield made a 50 bps move in just 5 trading days.
Bond yields have retraced some of that surge, but upward pressure remains. The ultra-long duration Treasury ETF TLT 0.00%↑ is now flat YtD. It has given up all of its 20 percentage points lead it had vs. the S&P 500 in early April.
Investors are quite nervous about a potential crash of the Treasury market and what that might mean for stocks and the economy. These fears are related to excessive deficit spending and potential capital account retaliations of trading partners due to the current trade war.
Let’s think through all of these concerns step by step.
What if interest rates spiral out of control?
As I have discussed in the article below, there is about $60tn in US Dollar liquidity out there, which includes all public and private debt owed to private sector creditors.
About half of that debt is issued by the US Treasury. They dominate US Dollar liquidity creation which makes them incomparable to a small borrower like any of us. Different rules apply to them. Studying this is like going from Newton to relativity theory when an object accelerates enough. They are not a price (aka interest rate) taker. They set the interest rate. It’s a quasi monopolist position in USD liquidity.
By cornering the market for US Dollar liquidity, the Treasury creates the demand for their securities themselves. The associated deficit spending drives the savings into the private sector so the Treasuries can be bought.
I, the government, give you a Dollar and borrow it back from you.
The Treasury market will always clear. They will never be no buyer. The only question is at what interest rate the debt originates. More on that later.
Before we do that, let’s visualize what happened if Treasury yields spiked to a crazy number, say 20%. There are $24tn of Treasury securities in circulation, i.e. not held by other government entities. If rates surged to 20%, the Treasury would be pumping $5tn of fiscal liquidity into markets per year. Plus the primary deficit on top. That's a fiscal impulse of 20% of GDP which would likely boost both asset prices and GDP. The last few years are a perfect example for that mechanism.
So, the public sector can deal with any interest rate. What about the private sector though?
What if private sector borrowers went bust from the rate shock?
It is important to understand that the US government is absolutely free in their decision about how much interest to pay to their creditors. Think about interest on government debt as entitlement spending just like social security. If they wanted to, the Fed could start buying every issuance tomorrow and force the Treasury's refinancing costs to zero (or any other number that they like). Alternatively, the Fed could cut overnight rates to zero and the Treasury could start to only issue bills which would lead to the same result. This could even happen instantly if the Treasury decided to buy back all notes and bonds to issue bills instead.
But would that not cause inflation?
How much inflation did we have from 2008 to 2014, when overnight rates were zero and three large QE programs expanded the Fed's balance sheet by a factor of 4.5x or $3.5tn? Barely 2%. And why? If the Fed started ZIRP tomorrow, the Treasury's annual deficit would fall from currently $2tn to less than $1tn. This would cause a demand shock in the economy which would be deflationary.
But what if the private sector uses low rates to lever up? That would certainly be inflationary?
It’s a fair concern and a theoretically sound idea. However, there is very little practical evidence that this would actually happen. For example, households deleveraged like never before through the 2008-2014 ZIRP age.
Growth in loans and leases was very low. The chart below plots growth in loans and leases vs. the Fed Funds Rate. Very hard to see any negative correlation between both metrics, isn’t it?
The truth is that low interest rates come with low economic growth, low inflation and little optimism. People don't lever up in such an environment. Especially not when the majority of them is heading for retirement like now.
What about pumping asset prices though?
Even if consumer prices don’t react to rate cuts, you might want to object and point to asset prices. After all, low rates increase the present value of corporate cash flows and should drive asset prices up, right?
This is also a strong theoretical argument that has very little support in reality. Over the years, I have never managed to find any negative correlation between interest rates and earnings multiples or market returns. In fact, the ZIRP+QE age of the 2010s came with earnings multiples significantly below average.
The most plausible explanation for this is that easy monetary policy limits the fiscal impulse, reduces economic growth and inflation (thereby lowering investor risk appetite), weakens the currency and makes the country unattractive for foreign investors.
But what if the Fed doesn’t comply?
I argued above that surging interest rates are not a threat because the US government can manipulate rates down if they choose so. Note that ‘the government’ always includes the Treasury and the Fed when I talk about it. They conduct economic policy together, albeit at times not in conscious agreement.
This argument is predicated on the assumption that the government would indeed do so should private sector stress occur. You may have doubts about that. I certainly don’t. The Fed has a treble mandate: Maximum employment. Price stability. Moderate long-term interest rates.
Obviously they would ease should the tight monetary environment force the private sector to its knees with rising unemployment. Especially once they realize that rate cuts will do very little in terms of reflating the CPI.
By the way, Powell's term is up in 2026. Trump will appoint whatever puppet he wants then. The Fed is ultimately just an agent of the federal government.
What about the ominous refinancing wave?
Some people argue that there is a lot of Treasury debt to be refinanced this year and that this is a problem for the current administration. It’s Yellen’s legacy who issued bills at a pace like nobody ever before.
The idea is that it is problematic for the Treasury if this debt gets refinanced at significantly higher rates putting public finances under pressure. Some go as far as suspecting he is crashing the economy deliberately to avoid a refinancing crisis.
There are a few comments I want to make here.
Firstly, crashing the economy on purpose to avoid a potential crash from a refinancing crisis is so nonsensical that I doubt even Trump could come up with such a plan. It’s like tearing your house down because you smell a forest fire nearby.
Secondly, there is no budget for interest expenses. The Treasury just pays whatever the market (and that means the government) wants. If the market wants higher rates, they will simply issue more debt.
Thirdly, I want you to think for a moment what it means if nobody wants to buy the debt of the US government. There are trillions of Dollars of capital flowing into financial markets every year from dividends and retained earnings of corporations, savings of households, international trade proceeds, interest payments from the Treasury and other borrowers to name a few. That money buys financial assets from those who want to sell them (retirees, companies raising capital to invest or generating losses, governments running deficits).
If this money doesn’t buy Treasuries, it is buying higher risk assets. And why? Because those investors see better investment alternatives. Because they expect outperformance of higher risk assets. And why? Because they expect economic growth. They expect high productivity of the liquidity provided by the deficit spending.
If the financial system shows cracks in any shape or form, more of that capital will flow to the Treasury, not less. The Treasury is the safest issuer of all because they can create the currency used to repay its issuance. A true risk off therefore has to come with lower interest rates. As long as higher rates prevail, it means that the machine is working.
Real interest rates are currently as high as they were before the GFC when growth was propped up by excessive leverage of US households. The real risk for the stock market is that growth expectations priced into Treasury yields will come down.
But what if trading partners attack the Treasury?
For many years, the rest of the world has been happy to reinvest their trade proceeds into the US with a large amount pouring straight into Treasuries. Foreigners own almost $9tn of the Treasury market, 35% of the total amount (excl. intragovernmental holdings and Fed holdings).
Some people fear that foreigners could weaponize these holdings in the current trade war.
It’s a large number, but it needs to be contextualized. Foreigners don’t just buy Treasuries with their trade proceeds. They buy into the US economy as a whole. The gross claim of foreigners on US domiciled assets currently stands at $62tn. This primarily includes portfolio investments (equity and debt securities) and direct investments (controlling stake of 10% or more).
So, while Treasuries are an important pillar to the investment strategy of foreigners, it is by far not the only one.
If the trade war really escalates to a point where foreigners withdraw capital from the US at a large scale (or stop buying), they will do so from all categories, including stocks. The entire US economy will suffer from that capital drain. Incomes will fall (or grow less) and so will consumption. The capital that stays within US borders will have to rerate prices to reflect that shock. Most likely this would mean lower interest rates and lower asset prices.
Will high rates really not tank the stock market then?
In my opinion, the most important thing to understand about interest rates is how they are linked to GDP growth. If GDP grows a lot, fixed income investors will demand compensation for foregoing returns in productive assets with a higher beta to GDP and for bearing inflation on their cash flows. That's why rates and nominal growth correlate so strongly. As an equity investor in a fiscal dominance regime, you want high interest rates because they come with high equity returns. You want to fear low rates because they are the horseman that the end of the bull market has come.
Sincerely,
Rene
Nah. There are better things to worry about.
Such as the price of gas.