US Treasury bonds have long provided domestic and foreign investors a modest yield that was assumed to be risk free. Yields (and thus prices) could be volatile, but the risk of the US government defaulting on its debt was regarded as so low that US Treasury yields became a benchmark for all other government and corporate debt: If the US government had zero risk of default, the default risk of any other borrower could be simply measured by looking at the additional yield it offered over a comparable Treasury security.
But there are increasing signs that this fundamental assumption about US government debt risk may not hold in the years ahead. While the US dollar and the 10-year Treasury’s real yield (the yield after accounting for inflation) tend to move in concert, that changed on 2 April when the dollar plunged and 10-year real yields saw their largest weekly rise in a quarter of a century (see Exhibit 1).
This sudden divergence was rapidly corrected, but left many bond holders feeling like there had been a shot across the bow. Indeed, the rapid correction came immediately after the White House administration paused the bulk of its announced tariffs, a policy reversal that many saw as a direct reaction to the Treasury market’s strong response.
Meanwhile, credit default swaps (CDS), a derivative security which measures the probability of a bond defaulting, have risen. Current CDS prices suggest the risk of the US government defaulting on Treasury securities is at similar levels to Italy, where structural debt problems have long been an issue, and Greece, where financial mismanagement sparked the 2011 European financial crisis.
Using CDS as a proxy measure of confidence in fiscal management, their current levels place the market’s degree of confidence in the US government below that of lower rated countries such as the UK (rated AA), France (Aa3) and Spain (A).
The US budget deficit
The Trump administration has been relatively consistent in its goals for government spending. It wanted the existing tax cuts extended and additional tax cuts added to help fuel economic growth.
To pay for tax cuts, the administration believes a combination of tariff revenues, increased domestic manufacturing activity and a pro-growth regulatory environment can largely offset the lost revenue from lower taxes.
The One Big Beautiful Bill Act (OBBBA) signed into law by President Trump on 4 July is projected to leave budget deficits around the currently high levels (5.2-6.5% of GDP; see Exhibit 3). The actual path will depend partly on the amount of revenue raised by tariffs, which is still uncertain given the ongoing negotiations.
The level of government debt is also projected to rise (see Exhibit 4).
While the US has run large deficits in the past, there is a growing sentiment in financial markets that debt levels are increasingly reaching a tipping point, in large part due to the massive spending during and after the Global Financial Crisis (GFC) in 2008 and the Covid pandemic in 2020.
Today, most economists believe the US government has been on an unsustainable fiscal trajectory, with one administration deferring to the next the difficulty of implementing a more prudent fiscal policy.
The One Big Beautiful Bill Act may raise the ratio of debt to GDP even higher. Markets are increasingly asking when, and how, the government can return to a balanced budget or, ideally, a budget surplus that can help lower the country’s absolute debt levels.
The necessity of confidence
Estimates of a country’s total outstanding debt level or debt-to-GDP ratio feed directly into the algorithms used by credit rating agencies to estimate a country’s probability of default.
There are also qualitative metrics used by investors to gauge risk when lending money to a government. The US has long benefited from the assumption – it is even a cornerstone of the modern financial system – that the US will never choose to default, and it will never need to. If the government ever faced problems paying outstanding debt, the US Treasury could simply print more money, albeit at the risk of higher inflation and less faith in the value of the currency.
That assumption is being questioned by some. In the first half of 2025, the US dollar declined by more than 10% (as measured by the DXY Index), the biggest six-month drop since the Global Financial Crisis (GFC).
The strength of the US economy stems partly from strong rule-of-law, robust regulation, free trade (or at least an openness to competition), a university system fuelling an ecosystem of patents and entrepreneurs, and confidence in policymakers, particularly the Federal Reserve (Fed).
Over the past few decades, when there was a massive disruption to the financial system – such as the GFC or the pandemic shock – heads turned to US financial policymakers. And for good reason: the assumption that the US Treasury and the Federal Reserve contained leadership willing to take the unpopular but prudent actions needed was rewarded time and again – whether it was the recapitalisation of the global banking system after 2008 or simply the fact that in the last 40 years the US economy has had only three recessions – and only one of those (post GFC) lasted more than a year.
Now, though, uncertainty about economic policy and the continued independence of the central bank – something coveted by investors in emerging economies – has diminished that confidence.
The bond market’s power
Many investors, whether individual, institutional or central banks, are re-evaluating the role of US Treasuries in their portfolios. Not because they think the risk of default is too high (it is not), but because there is more focus on the risk of a kind of ‘perfect storm’: A growing budget deficit on top of a weaker economy, rising inflation and an erosion in institutional stability – or simply prolonged market volatility because of all these concerns.
Luckily for the US, there is no clear alternative to the Treasury market.
This may be Europe’s moment to establish the euro and eurozone government bonds as compelling alternatives – accelerated German Bund issuance and regional fiscal integration would be steps in the right direction. But eurozone bonds and the euro need time before they can firmly establish themselves as credible alternatives to dollars and Treasuries. For many investors, including central banks, gold has been the favoured alternative to Treasuries.
It remains an open question as to who will buy all the Treasuries needed to finance a large or growing budget deficit. Some recent Treasury auctions have gone poorly and, while there are many factors in play, the risk that confidence continues to erode until it reaches a tipping point is not trivial.
Markets, as we saw during the GFC and Covid, can snowball quickly, with increasingly higher risk premiums requiring increasingly lower prices, until policymakers who have the market’s confidence intervene.
Sometimes the bond market forces their hand in a dynamic that gave rise in the 1980s to the term ‘bond vigilantes’.
Most famously, the ‘Great Bond Massacre’ of 1993-1994 saw 10-year T-note yields rise from near 5% to 8% because of concerns about federal spending under the then Democratic President Bill Clinton. In response, the Clinton administration and a Republican-led Congress agreed to a plan to reduce the deficit, allowing interest rates to fall over the following years. More recently, former UK Prime Minister Liz Truss had to withdraw a largely unfunded budget after the UK government bond saw yields surging to multi-year highs.
Even though there is broad agreement that the US government debt burden is unsustainable, Congress will likely continue to spend as much as it can until there is a more forceful response from markets.
Given the difficulty in cutting significant amounts of spending from a budget with a relatively small amount of discretionary spending, and with economic growth unlikely to surge sufficiently to change the deficit trajectory, we expect the bond market will eventually demand a higher risk premium than the government can afford.
Positioning for a potential loss of confidence
First, it is important to keep in mind that however swift or severe a collapse in confidence could be in the bond market, it is likely to be short-lived. As we have already pointed out, the current administration was quick to change trade policy after Treasury yields spiked and the dollar fell in April. Policies could again change rapidly if there was a perception that investor sentiment had tipped.
Volatility would likely be high through the transition and the yield curve would likely steepen. In this environment, shorter-duration Treasuries should outperform, and could see positive total returns if monetary policy rates were forecast to be lowered.
Some diversification into similarly rated government bonds, such as European government bonds, or more structured securities, could help dampen a portfolio’s overall volatility. US mortgage-backed securities (MBS), for example, carry the same credit rating as Treasuries, but are less sensitive to the absolute level of interest rates, and could benefit from a drop in prepayment expectations as mortgage rates follow Treasury yields higher.
Corporate bond returns, whether investment-grade or high-yield, are heavily influenced by the changes in underlying Treasury yields. A rise in uncertainty could see their yield spreads over those same Treasuries widen, at least temporarily. High- yield securities, given the issuing companies’ greater reliance on debt-financing, could see particularly significant spread widening should borrowing costs surge.
More broadly, traditional government and corporate bond investment strategies tend to track their benchmarks closely. As such, there is less latitude for an active manager to protect against a rise in longer-dated Treasury yields without incurring too much tracking volatility (a measure of the difference between a portfolio’s exposures and those of its benchmarks, which is usually capped).
A more absolute return or income-driven approach, however, where the constraints of a benchmark give way to a targeted absolute return or income, could offer more diversification and potentially be better able to preserve returns. By allowing for a wider range of investable instruments such as corporate bonds, emerging market government or corporate bonds, and structured securities, absolute return and income strategies allow for greater exposure to securities that could outperform should Treasury yields spike.
Should it become clear that a solution to the deficit problem is to intentionally allow higher inflation over an extended period, then Treasury Inflation-Protected Securities (TIPS) could outperform nominal bonds as Treasury yields could be slower to recover due to expectations for sustained higher inflation.
Similarly, to the extent that a weaker dollar is perceived as a favoured way to repay Treasury bond holders, that, too, could put pressure on inflation, benefiting TIPS relative to Treasuries in the aftermath of a correction.
While the risk of a collapse in confidence could be growing, there will likely be periods of optimism that follow periods of pessimism. There are many scenarios in which some or all of the current uncertainties around US trade, employment, monetary and fiscal policy could be resolved in a way that markets can price in, or at least more confidently predict. This would allow markets to adjust in a more controlled fashion, avoiding or at least significantly delaying any sudden collapse in confidence.
But each year that the US government plans for large deficits, the need for a solution compounds. While a disorderly crisis is not our base case expectation, it is increasingly a possible outcome and, given its potential for a significant short-term impact on bond portfolios, one that deserves attention and preparation.
