Khan Capital | October 2023
Key Takeaways
- The 10-year Treasury yield touched 5.0% for the first time since 2007, capping a six-month surge of 175 basis points that produced the most severe bond bear market in a generation and a third consecutive annual loss for the Bloomberg Aggregate, unprecedented in nearly 50 years of data.
- The sell-off was driven by the Fed’s “higher for longer” messaging, the return of the term premium as QT reduced central bank demand, a $1.7 trillion fiscal deficit at 6.3% of GDP, and retreating foreign buyers as China and Japan reduced Treasury holdings.
- The interest expense feedback loop (higher yields increase interest costs, which increase deficits, which increase supply, which push yields higher) is a structural force that will influence the Treasury market for years regardless of the economic cycle.
- For income investors, 5% nominal and approximately 2.5% real yields on the 10-year Treasury represent a generational entry point that was unavailable for over 15 years.
- The equity risk premium has been compressed to its lowest level in over 20 years, fundamentally altering the relative attractiveness of bonds versus stocks and raising the hurdle rate for equity ownership.
On 19 October 2023, the yield on the 10-year US Treasury note briefly touched 5.0%, a level not seen since July 2007. The move capped a relentless sell-off that had taken the benchmark yield from 3.25% in April to 5.0% in six months, one of the fastest and most violent repricing of government borrowing costs in modern history. The 30-year yield had surpassed 5.1%. The Bloomberg US Aggregate Bond Index was on track for its third consecutive annual loss, an outcome that had never occurred in the index’s nearly 50-year history. The bond market, which had spent decades in a secular bull market characterised by falling yields and rising prices, was experiencing its most severe bear market in a generation.
The market called it the return of the bond vigilantes: the notion that investors will refuse to finance government profligacy at low interest rates and will instead demand higher yields to compensate for the risk of holding sovereign debt in an era of persistent deficits, rising supply, and uncertain inflation. Whether the vigilantes have truly returned, or whether the sell-off reflects more prosaic factors (Fed policy, supply dynamics, positioning), is a debate that goes to the heart of how investors should think about fixed income in the years ahead.
The Drivers: Why Yields Surged
The Fed’s “higher for longer” message. The most important catalyst was the Federal Reserve’s persistent communication that rates would remain elevated for longer than markets had initially expected. The September 2023 dot plot projected only one rate cut in 2024 (revised from the market’s expectation of several), and Chair Powell’s press conferences emphasised that the Committee was “not confident” that inflation had been durably conquered. The front end of the curve repriced accordingly, but the long end sold off even more aggressively, reflecting a repricing of the entire rate regime rather than just near-term policy expectations.
The term premium’s return. For most of the 2010s, the term premium, the additional yield investors demand for holding long-duration bonds rather than rolling short-term instruments, was negative or near zero, reflecting the QE-driven demand from central banks that compressed long-term yields below their fair value. As the Fed pursued quantitative tightening (allowing its bond holdings to decline) and Treasury supply increased to finance growing deficits, the term premium turned positive for the first time in years. The return of the term premium is a structural shift: investors are now demanding compensation for the risk of holding long-duration government debt, a risk that QE had artificially suppressed for a decade.
The fiscal deficit. The US fiscal deficit exceeded $1.7 trillion in fiscal year 2023, approximately 6.3% of GDP, a figure normally associated with recessions or wartime rather than an economy growing at 2%+ with unemployment below 4%. The Congressional Budget Office’s projections show deficits exceeding $2 trillion annually for the foreseeable future. The Treasury’s quarterly refunding announcements, which detail the composition of new debt issuance, became market-moving events as investors assessed the volume of supply they would be asked to absorb. The August refunding announcement, which increased the size of long-dated auctions more than expected, was a proximate catalyst for the late-summer sell-off.
Foreign buyer retreat. Foreign central banks, historically among the largest purchasers of US Treasuries, have been reducing their holdings. China’s Treasury holdings have declined from a peak above $1.3 trillion to below $800 billion. Japan, the largest foreign holder, has been selling Treasuries to defend the yen. The combination of reduced foreign demand and increased supply created a buyer-seller imbalance that pushed yields higher.
What the Market Is Misunderstanding
5% yields are not just about monetary policy; they are about fiscal sustainability. The market has been trained to view Treasury yields through the lens of Fed policy: the Fed raises rates, yields go up; the Fed cuts rates, yields go down. The 2023 sell-off is different because a significant portion of the yield increase reflects a fiscal risk premium that is independent of the Fed’s rate decisions. Even if the Fed begins cutting rates in 2024, long-term yields may not decline proportionally if the market continues to demand a higher premium for the fiscal risk embedded in growing deficits and rising Treasury supply.
The interest expense feedback loop is accelerating. With over $33 trillion in federal debt outstanding and a weighted average interest rate that is rising as maturing low-coupon debt is refinanced at current yields, the government’s interest expense is growing rapidly. Net interest payments exceeded $650 billion in fiscal 2023, surpassing defence spending for the first time. Higher yields increase interest expense, which increases the deficit, which increases Treasury supply, which pushes yields higher still. This feedback loop is a structural force that will influence the Treasury market for years, regardless of the near-term economic cycle.
The “buy the dip” instinct in bonds is being tested. Decades of a bond bull market have conditioned investors to buy Treasury sell-offs as opportunities. But a secular shift from falling yields (capital gains) to rising yields (capital losses) requires a fundamental rethinking of fixed income strategy. If the 40-year bond bull market that began with Paul Volcker’s inflation fight in 1981 is truly over, the strategic approach to bonds shifts from duration-as-return-enhancer to duration-as-risk-to-be-managed.
Implications for Investors
5% yields create a generational opportunity for income investors. For the first time in over 15 years, the 10-year Treasury offers a yield that exceeds long-term inflation expectations. The real yield (nominal yield minus expected inflation) is approximately 2.5%, the highest since the pre-financial-crisis era. For investors with long time horizons (pension funds, endowments, insurance companies), locking in 5% nominal and 2.5% real yields on risk-free government debt is an attractive proposition that was unavailable for over a decade.
Duration risk should be managed actively. The lesson of 2022-2023 is that long-duration bonds can lose 30-40% of their value in a rising rate environment. Investors should match their fixed income duration to their liquidity needs and risk tolerance rather than defaulting to the Bloomberg Aggregate’s benchmark duration.
TIPS (Treasury Inflation-Protected Securities) offer value at current real yield levels. With 10-year TIPS yielding approximately 2.5% real, these instruments provide explicit inflation protection at a historically attractive price. If inflation remains above 2% and rates begin to decline, TIPS would benefit from both the real yield lock-in and price appreciation.
The equity risk premium has been compressed. With the risk-free rate at 5%, the hurdle for equities is now meaningfully higher. The equity risk premium (the excess return stocks must offer over bonds to justify their risk) has declined to its lowest level in over 20 years. This does not mean equities will fall, but it does mean that the relative attractiveness of bonds versus stocks has shifted materially in favour of bonds for the first time since the pre-pandemic era.
Conclusion
The 10-year Treasury at 5% is both a threat and an opportunity. It threatens equity valuations by raising the discount rate and compressing the equity risk premium. It threatens the fiscal outlook by increasing the government’s borrowing costs in a feedback loop that has no obvious resolution. But it also offers fixed income investors the most attractive entry point in over 15 years, with real yields that exceed historical averages and a carry return that compensates for meaningful duration risk. The bond vigilantes may or may not have permanently returned, but their message is clear: the era of free government borrowing is over, and the market is demanding compensation for the fiscal, inflation, and duration risks that a decade of QE had obscured.
Related Reading
The bond vigilante return was part of the broader fixed income crisis covered in The Global Bond Bear Market. For the hiking cycle that drove yields higher, see The Fed’s Most Aggressive Hiking Cycle. For how the elevated rate environment contributed to the unravelling of the private credit boom, see The Private Credit Crackup: Blue Owl, Redemption Gates, and the Liquidity Illusion. The yield curve’s predictive power was tested again when 10-Year Treasury Hits 5%: Bond Vigilantes Return.
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