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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation report for 09/22/2025. I'm Phil Adler. With deficits rising, governments may resort to different strategies to help keep interest rates in check. Confluence Associate Market Strategist and Certified Business Economist Thomas Wash joins us today to examine the landscape for government bonds and also the message markets are sending to investors. Thomas, the title of this week's report is "Stopping the Bond Vigilante: How Fiscal Dominance Is Reshaping Global Markets."
Phil Adler:The term bond vigilante has been around for a while. Correct me if I'm wrong, but I understand the term refers to an investor who sells or threatens to sell government bonds, driving yields higher with the aim of forcing governments to become more fiscally responsible. Now has this strategy worked in the past? Have bond vigilantes actually been able to impose fiscal discipline on free spending governments?
Thomas Wash:I think that's a great question, Phil. You know, the concept of bond vigilantes isn't new, but it truly seized the world's attention in the 1990s. When a sharp spike in government bond yields forced the US to address its
Thomas Wash:soaring budget deficit, the resulting fiscal discipline succeeded in bringing interest rates back down. Now this episode demonstrated the market's immense power so clearly that it inspired a now famous quip from Democratic strategist James Carville. He said, "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a 400 baseball hitter.
Thomas Wash:But now I would like to come back as the bond market because you can intimidate everybody."
Phil Adler:Well, looking at the possible impact of bond vigilantes on today's markets, has demand for US government bonds shifted in any major way because of our rising national debt?
Thomas Wash:Well, you know, yes, I would say there's a noticeable shift in the US Treasury market. Investors are increasingly favoring short term bonds over long term debt due to growing concerns about inflation and economic uncertainty. This lack of appetite was recently highlighted by a poorly received auction of 20-year bonds. These investors' fears echo concerns of rating agencies. For example, Moody's just recently downgraded the US credit rating, becoming the last major agency to do so.
Thomas Wash:Their decision reflected a weaker fiscal outlook fueled by doubts that US lawmakers have a credible plan to reduce the deficit or manage the national debt.
Phil Adler:Well, how about demand for government bonds in other developed countries? Are markets there more or less tied to the United States?
Thomas Wash:I do think that's an interesting point. While we have indeed seen a global rise in long term bond yields, I would be cautious about attributing it to a single direct cause. However, I do believe the trends are somewhat related. We are seeing bond investors grow increasingly skeptical of government bonds, in general, that are failing to address their massive debt accumulated during the pandemic. The core concern is that this debt is being racked up without necessary economic growth to sustain it.
Thomas Wash:This synchronized skepticism was evident, for example, when a weaker auction for US bonds was quickly followed by a similarly weak auction for Japan's 30-year bonds.
Phil Adler:It appears, Thomas, that governments are adjusting how they issue bonds to prevent interest rates from rising out of control. What's happening?
Thomas Wash:That's right. You know, governments are strategically adjusting their issuance to navigate a challenging market. Recognizing that supply of long term bonds could overwhelm investor demand, some government agencies are reportedly reducing the frequency of long dated bond auctions. Instead, they're favoring the issuance of short and intermediate term bonds, which have seen stronger and more consistent investor appetite. This deliberate shift in strategy has helped to alleviate upward pressure on long term interest rates by better balancing market supply and demand.
Phil Adler:But it might seem that governments which are issuing more short term debt might eventually have to face the music. Short term debt expires in the short term fairly quickly, and refinancing might come at a sharply higher cost. Do you see a moment of truth arriving at some point when rates might surge as debt rolls over?
Thomas Wash:Well, that's a critical point, Phil. Shortening public debt maturities amplifies rollover risk, forcing more frequent refinancing and exposing public finances to swings in short term rates. A sharp increase would raise borrowing costs dramatically, threatening debt sustainability and fiscal stability. However, we believe that the governments of major economies possess both the tools and the overwhelming incentive to intervene and prevent a systemic crisis. The catastrophic consequences of a sovereign default make intervention the only politically and economically viable course.
Phil Adler:Now the title of your report refers to governments evolving to a strategy of fiscal dominance to prevent economic instability. What are the hallmarks of this strategy?
Thomas Wash:So, fiscal dominance occurs when a nation's debt burden grows so large that it forces central banks to intervene, subordinating its monetary policy to fiscal objectives. The central bank typically acts to make national debt more manageable by keeping interest rates artificially low or by purchasing government bonds. This phenomenon is not merely theoretical. It was observed in the United States during the Korean War when the Fed was pressured to cap yields. More recently, the Bank of Japan has implemented yield curve control, effectively capping its 10-year bond yield to manage the world's largest public debt burden.
Phil Adler:What about the message the bond market is sending investors right now? Can we go so far as to describe it as confidence in the ability of governments to control interest rates pressured by rising budget deficits?
Thomas Wash:Not quite. I think that the concern is that a rising supply of government debt will fuel inflation. Bondholders are growing reluctant to finance long term debt. Consequently, these investors are pushing for fiscal discipline through either budget cuts or tax increases to ensure governments can manage their debt obligations more sustainably.
Phil Adler:Where do fixed income investors find value in this type of environment?
Thomas Wash:In the current market, I do believe a barbell strategy presents a compelling approach for fixed income investors. This tactic, which involves holding both short and long duration bonds while avoiding the middle of the yield curve, is supported by dual tailwinds. On the short end, eminent central bank rate cuts are poised to drive capital appreciation. On the long end, favorable supply dynamics due to reduced government issuance and the potential for central bank buying programs to alleviate fiscal pressures should bolster returns. Separately, sovereign governments demonstrating a credible commitment to debt sustainability, notably in the peripheral eurozone, could see outsized demand.
Phil Adler:Are there benchmarks that we investors should pay particular attention to? For instance, a yield of 5% on the 30-year Treasury?
Thomas Wash:Yeah. You know, I'd say that when, for example, the US Treasury yield rises above 4.7%, this could present a buying opportunity, especially if the Federal Reserve signals its intent to lower rates at its next meeting. A flight to safety triggered by signs of an economic downturn would also increase demand for bonds and push yields lower. However, as rates approach 3%, investors face the risk of a negative real interest rate where the return on their investment is less than the rate of inflation. This risk is particularly high if inflation starts to pick up, effectively eroding the purchasing power of the bond's return.
Phil Adler:As unlikely as it seems, governments could do something unusual like raise taxes and cut spending to rein in these deficits that are pressuring interest rates. But here in the United States, I'm looking at another pool of money, maybe another possibility. Do you see our government using funds raised through tariffs? And there's a pool of it accumulating right now, to use that money to address the fiscal deficit to help keep interest rates in check?
Thomas Wash:While tariffs can generate government revenue, they're still a minor source compared to other income streams and are not a viable solution for significantly reducing the national deficit. You know, tariff revenue – despite reaching new highs – typically accounts for less than 5% of total federal tax receipts. So, for the US government to pay down its immense debt, it would need to rely on more impactful measures such as a combination of major tax increases or significant cuts to government spending.
Phil Adler:Thank you, Thomas. The title of this week's report is "Stopping the Bond Vigilante: How Fiscal Dominance Is Reshaping Global Markets." You can find a link to the written report on the Confluence website, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice.
Phil Adler:This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole. I'm Phil Adler.