Return of the bond vigilantes

Posted 23 May 2025

After weeks of unimpeded recovery, this week’s pull back in global stock prices was probably to be expected. The story that Trump is back on the tariff war-path with the EU, planning to impose 50% levies (possibly before the “90-day” deadline) has pushed all developed markets as we write. After the period of playing nice, many investors expected some nastiness so the shock will be limited, and seen as a negotiating tactic. This story will unfold over the coming days.

From Monday to Thursday, equity markets had been soggy. UK equities fared decently despite some troubling inflation news – and we dedicate two separate articles to UK news this week – but the US sold off somewhat. That brought down aggregate global stocks with it, while the dollar weakness returned. The only news story offered as explanation was the passage of Donald Trump’s “Big Beautiful Bill” of tax cuts through the lower chamber of US congress (The One, Big Beautiful Bill is indeed the budget bill’s official name).

The irony of this narrative is that the bill’s proposed tax cuts are part of what excited US investors at the beginning of this year – but there is now another side to it. More to the point, equities are suffering from a consistent rise in government bond yields (the ‘risk free’ rate) of which rising fiscal instability expectations due to unfunded tax cuts is one part (we all remember the UK’s ‘Mini Budget’ episode). The other parts are due to overall risk perceptions of US assets, previously considered the world’s safe haven.

The bond sell-off has echoes of 2022.

Most regions’ stock markets were fairly flat through the week, but the US’ vast share of global market cap meant its losses were keenly felt by global investors. Even significantly stronger than expected US business confidence Purchasing Manager surveys, released on Thursday, were not enough to excite markets. Indeed, that economic strength pushed up government bond yields even further – making equities less attractive by comparison.

This year’s market movements have echoes of 2022, when fast rising bond yields put a ceiling on stock market returns. That period was about sharply higher short-term interest rates – which are now in a downward trend – but the risk perceptions for long-term bonds have increased just as then. Our equity valuation model, for example, is sensitive to long-term real interest rates, which are themselves sensitive to perceptions of the risk attached to government bonds (which we measure by comparing government yields to interbank swap rates). Basically, investors are more wary of lending to the government – as shown by weak demand in this week’s auction for a 20 year US treasury bond.

This is not just a problem for the US. Risk perceptions of long-dated government bonds have gone up everywhere, largely as a knock-on effect of US problems. The UK government, for example, has been at pains to prove its fiscal discipline, but no matter what Chancellor Reeves does, it feels like Washington has more influence over her borrowing costs than her own treasury.

The UK bond market is a fraction of the global bond market, but, briefly, shook the world in 2022 after the Truss budget fiasco. Then, last summer, Japan’s much larger bond market rocked global investors when the yen ‘carry trade’ unravelled. If the US – the world’s largest bond market – had a similar episode, the impact would be several orders of magnitude larger.

Bonds are Trump’s rock; equities are his hard place.

Trump’s Big Beautiful Bill will reportedly add $3.3 trillion over 10 years to a US budget deficit that many already consider unsustainable. The tax cut plan passed the House of Representatives, but it will face more resistance in the Senate, where old-school fiscally conservative Republicans are more prominent. Even so, tax revenues will be cut to some degree, and the recent bond sell-off has already signalled that markets are deeply concerned.

Interestingly, both Republican budget hawks and bond buyers seem to be hoping that revenues from Trump’s tariffs will offset some of the damage – approximately $2.1tn of it over 10 years, according to the Tax Foundation. Regardless of whether you think that figure will be accurate (consumer substitution effects are hard to predict), the conclusion is clearly that the president cannot afford to lower his tariffs any lower than he already has (and that may be part of today’s story).

But, lower tariffs are exactly what US equity markets have been excited about for the last month. Trump is therefore stuck between a rock and a hard place: stocks tantrum when tariffs go up; bonds will tantrum if they go down. There may well be a middle ground that provides revenue without crippling the economy, but walking it requires a level of finesse and consistency that the president has never really shown.

The longer policy uncertainty goes on, the worse the outcome.

The stocks-versus-bonds tension suggests that the different US asset markets are now competing for much of the same capital. That has not been the case for many years. US stocks and bonds are rarely short of investors at home or abroad – thanks to continued inflows. Those inflows have been supported, for more than a decade, by world-leading profit growth and the US’ safe haven status. But that exceptionalism has been thoroughly undermined this year, and US underperformance is now looking like a trend that will be hard to reverse.

Long-term bond yields, at historic highs, certainly have room to come back down – especially if economic data weaken – but a bond market recovery requires policy stability. On that front, it is worth remembering that we are about halfway through Trump’s 90-day tariff suspension, and many of the world’s most important trade relationships – like the US and EU – are no closer to resolution.

We have made the point before that small US companies tend to have higher leverage and are weighed down by higher debt refinancing costs. The base of these costs is increased by the move up in ‘risk free’ government bonds. But, because their debt is shorter-dated, these current long-dated yield rises are perhaps not as big an issue. For mid-cap and larger-cap borrowers, the rise in longer dated yields is a problem they thought was going away. It affects both their refinancing costs and equity valuations. Clearly, resilient data says the US is not close to a recession at the moment, but higher bond yields mean the risk is not negligible.