Remarkably, even though the US Federal Reserve has lowered the Fed funds rate by 100bp since last September, US bond yields have risen sharply (roughly 100bp). Market commentators have offered a wide range of explanations for this unusual development. As the incoming Administration has signalled a significant shift in economic strategy, investors will need to sift through this confusion. Indeed, to evaluate the future direction of bond markets, we must understand what lies behind the rise in US long-term interest rates, e.g. what’s already priced into the market. So far, equity markets have remained relatively relaxed about rising yields. And, the US dollar has continued to appreciate. What might cause these benign reactions to change?

Rising Bond Yields: Inflation or Something”Real”?

Fortunately, financial markets themselves provide many valuable clues. Economists tell us long-term interest rates consist of two components: inflationary expectations and a “real” yield (what’s left after inflation). Many pundits have attributed higher US yields to renewed inflation concerns. However, the Chart above indicates higher inflationary expectations account for only about 25% of the rise in long-term rates since last Autumn.

Indeed, the Trump Administration inherits a promising inflation outlook. To be sure, price growth has remained “sticky” in recent months. However, the Chart above illustrates that wage growth — a key driver of inflation — has decelerated during the past two years. Indeed, with unit labour cost now rising only 2%, the Fed should be able to achieve its inflation target over the medium term.

That is, unless the Trump economic program upsets this favourable trend. In an earlier blog, I suggested the proposed tariffs hikes could increase US prices by up to 4%. Clearly, financial markets believe President Trump’s bark will be worse than his bite, as it was during his first term. Indeed, the political consequences of renewed infation could be significant (ask Joe Biden). While I would tend to agree, I really have no idea. However, even if Trump imposes the threatened levies only on China, Canada, and Mexico, US prices could rise up to 2% (of course, it could be less if either foreign producers or US retailers absorb the cost in profit margins). Likewise, if deportations exceed the 1-1.5 million I anticipate, wage growth may accelerate again.

As the US bond market has adopted a “wait and see” posture, the inflationary potential of tariffs deportations pose an important risk to bond yields in the coming period.

The “Real” Problem: Tax Cuts Add to Spiraling Debt

Therefore, the key driver of rising US bond yields has been higher “real” (inflation-adjusted) interest rates (see the first Chart). Many commentators suggest this reflects accelerating US economic growth. Again, while the new Administration inherits a health economy, recent PMI surveys do not suggest activity has accelerated noticeably since last summer (Chart above). Likewise, while recent employment gains remain robust, job growth is no longer as strong as earlier in the recovery.

The main culprit for rising US bond yields, therefore, is the unsustainable state of American public finances. Under current law, the CBO projects US Federal government debt will continue to spiral unsustainably during the next decade. However, President Trump’s campaign pledges will add to the burden (Chart above).

The Chart above indicates the scale of the task. In order to simply stabilise the debt ratio, the USA must cut its primary deficit (excluding debt interest payments) by 4-5% of GDP over the medium term — one of the largest required fiscal adjustments in the world. The following Chart illustrates both higher government spending and the TCJA tax cuts have contributed to the US budget problem in recent years.

In a recent blog, I indicated planned mandatory spending on health care and social security, as well as higher interest payments and defense expenditures, would complicate the task. Indeed, despite projecting declining non-defense discretionary spending, the CBO indicates US deficits will remain near 6% of GDP (next Chart).

During the next 100 days, financial markets will get a glimpse of how the new Administration will address this problem. At a minimum, spending cuts of $4-5 trillion will be required to pay for the planned extension of the TCJA tax cuts. But, this does not even begin to address the underlying problem. Stabilising America’s debt ratio will almost certainly require politically difficult changes in popular health and retirement spending. Alternatively, virtually all non-defense discretionary spending would need to be eliminated. Of course, that’s not feasible…politically or practically.

Such radical spending cuts were never discussed during the lengthy and expensive US election campaign. No wonder I’m cynical about politics! And, Elon Musk’s public sector efficiency plans (or curbs on government hiring) will not solve the problem. No doubt, President Trump will blame the problem on his predecessors, although deficits were equally large already pre-Covid. The unavoidable tough decisions may lead to a clash between President Trump’s populist rhetoric and Messrs Musk’s and Bessent’s aspiration to cut the deficit.

Deficits, the Fed, and Markets

• Until the Trump Administration’s fiscal program becomes clear (as well as its plans for tariff hikes and the scale of deportations), the Federal Reserve will take a more cautious approach. Additional rate cuts are likely to be delayed until June or beyond. A clash between the Fed and Trump may be imminent.
• In the past the Fed indicated the terminal short term interest rate in this cycle would be near 3%. However, without fiscal tightening, the “natural” interest rate may be as high as 4%. The Fed may signal this shift in thinking at its upcoming meeting.
• In the absence of deficit reductions, US bond yields may remain in the 4.5-5% range for much of 2025. And, they could spike higher if markets lose confidence in American debt dynamics.
• If so, equity markets may become less compacent. The Chart above (provided by Ed Yardeni’s research) illustrates the S&P 500 trades at roughly 22X 2025 EPS. And, equities are no longer cheap relative to bonds. If bond yields remain near 5%, the P/E multiple may need to adjust to 20X or less. Under these conditions, the index could slide towards 5,700 even using 2026 EPS projections.
• Alternatively, a “maximum bullish” scenario exists. If needed (and inevitable) fiscal adjustment takes place, the Fed could reduce interest rates even more than markets now expect, perhaps eventually towards 3-3.25%. Likewise, while it’s far to early to say, American productivity may be accelerating after its post-Financial Crisis slump (next Chart). Higher efficiency and stronger long-term GDP growth may help the USA grow its way out of the budget deficit problem. The S&P 500 could reach 7,500 in 2026. Lots to play for!

• US economic outperformance, along with higher tariffs and a cautious Fed, continue to point to a stronger US dollar for now. However, the greenback is quite overvalued (next Chart). As the UK discovered recently under former Prime Minister Liz Truss, the FX consequences can be serious if markets loss confidence in debt dynamics.