Let’s get down to basics.
Bonds represent loans to debtors. Like every other good, service and financial token, the price of a bond responds to supply and demand.
If supply rises while demand stays the same (or falls) the price will drop. Interest rates rise when the bond prices fall. Rising federal deficits pump huge amounts of bond supply into the bond market. That causes bond prices to fall.
Trillions of dollars of existing bonds will lose value when bond prices fall.
Federal spending is fiscal stimulus. It goes directly into consumer pockets. If spending rises faster than productivity (the supply of goods and services), prices will rise. That’s inflation. Inflation eats away the value of future dollars.
Lenders lock in a specific interest rate. We don’t want the value of our future interest income to be eaten away. On top of supply and demand for bonds, inflation uncertainty causes bond investors to demand a “term premium” - extra interest on top to compensate for the future uncertainty.
Since the 2008 financial crisis, the Federal Reserve has suppressed long-term interest rates by buying Treasury debt (Quantitative Easing or QE). Since the Fed can conjure money out of thin air, QE upsets the balance of supply and demand.
How Sky-High Deficits Threaten the Bond Market
Treasury is issuing record debt into a market increasingly unfriendly to profligate governments
By Greg Ip, The Wall Street Journal, July 17, 2026
The Federal Reserve isn’t in the bailout business, Chairman Kevin Warsh told Congress this week, especially not for the biggest debtor of all, the U.S. Treasury.
He did, though, append an escape clause: “In periods of crises like the 2020 pandemic and the 2008 crisis, central banks by design [need] to step into markets to create a fair price.”
He was wise to flag an escape clause. He might need it.
Near-record peacetime budget deficits mean the federal government must issue roughly $2 trillion a year in additional Treasury bills and bonds. Meanwhile, the Treasury market is changing shape: patient investors are making way for faster-moving opportunistic players dependent on potentially fragile funding. It is a combustible mixture…
The balance [48% of Treasury bond purchases] is in the hands of price-sensitive investors, who are quicker to buy or sell depending on market conditions.
Most prominent: between 2023 and last September, hedge funds’ share of Treasurys jumped from 4.5% to 8.5%, according to a Fed study. These funds aren’t typically betting on the direction of yields. Rather, they are doing arbitrage, such as buying a bond while selling an equivalent futures contract to another investor, pocketing the difference in price…
These hedge funds finance their bond buying with short-term “repo” loans from banks, collateralized by the bonds. This is a potential weak link. “A small number of dealers account for the bulk of repo lending to leveraged hedge funds,” the Bank for International Settlements recently noted. Imagine a scenario where banks pull back those loans because of stress elsewhere on their balance sheets. Repo rates would then surge, hedge funds could liquidate Treasury positions en masse, and yields would gyrate…
Would the Fed similarly come to the rescue if bond trading breaks down? …
The market does assume the Fed would step in. This makes sense: if the Fed bails out private market players to save the financial system, surely it should do the same for Treasury. But what if bond buying crosses the line from crisis prevention to helping Treasury borrow? That is called “fiscal dominance,” which compromises the central bank’s independence.
That line can blur during a crisis. Warsh himself has long criticized the Fed for continuing to buy bonds after the crisis had passed in both 2008 and 2020… [end quote]
Let’s look at the Fed’s purchases of Treasury and mortgage debt.
The Fed gradually tapered its massive book of bonds starting in 2022 but has recently begun to gradually increase it again. The Fed is holding over 1/5 of GDP worth of Treasury and mortgage bonds.
Barring an actual crisis, Kevin Warsh has said that the Fed should not interfere in the markets to protect investors.
https://www.cbo.gov/publication/62105
According to the non-partisan Congressional Budget Office, relative to the size of the economy, the deficit is 5.8 percent of gross domestic product (GDP) in 2026 and increases to 6.7 percent in 2036. Debt held by the public rises from 101 percent of GDP in 2026 to 120 percent in 2036, well above the previous record of 106 percent just after World War II.
There are a lot of moving parts in the bond market. Greg Ip points out that the growing participation of speculators can cause rapid changes in interest rates that weren’t seen in the past.
Many companies borrowed at ultra-low interest rates (2020 - 2022) during the Covid years when the Fed was suppressing yields with QE. A lot of this corporate debt was 3 to 5 years and will be maturing in 2026 - 2028. At the same time, AI companies are borrowing to build out data centers.
There’s a real risk that yields could rise rapidly and/ or fluctuate. The stock market will also be impacted, both fundamentally (from companies spending more on interest) and due to the higher cost of margin. Banks may reduce lending as their current bonds lose value.
As a bond investor, I plan to buy only TIPS and short-term bonds (5 years and shorter) until the situation clarifies. All long-term bonds, even TIPS, will lose value if interest rates rise. That’s why the 30 year TIPS yield is rising to a record high even though it’s inflation-adjusted.
Wendy