What's Behind the Big Surge in US Government Bond Yields

At Jackson Hole, Odd Lots hosts Joe Wiesenthal and Tracy Alloway interview Stanford economist Daryl Duffy to explore the surge in US Treasury yields, particularly long-dated bonds exceeding 5%. Duffy reframes the discussion around Treasury supply and investor demand dynamics rather than fiscal dominance concerns.

On yield drivers, Duffy argues that yields remain elevated because discretionary investors—pension funds, insurance companies, hedge funds, and mutual funds—have already satisfied their desired Treasury allocations at current yields. Foreign central banks have stopped net buying after years of accumulation. The US Treasury market has grown from $18 trillion to $31 trillion in recent years, with the government running deficits of roughly $2 trillion annually. This massive supply must be absorbed by domestic discretionary investors who demand higher yields for compensation. Duffy explicitly states inflation expectations are not showing alarm bells in market data, despite persistent above-target inflation over the past five years.

The hosts discuss Treasury Secretary Scott Besant's expanded buyback program, announced recently to address what Besant signaled were unjustifiably high yields. Duffy notes that dealer balance sheets remain in good shape and classical liquidity measures showed no distress at the time of the announcement, suggesting Besant's motivation was yield management rather than crisis response. He distinguishes between legitimate Treasury interventions during genuine market dysfunction (like March 2020) and signaling operations. Duffy notes that Besant's previous role as a hedge fund manager (in the Soros fund during the 1992 pound attack) may influence his market-active approach. He emphasizes that even powerful governments cannot permanently override market pricing of yields—governments attempting this, like Britain in 1992, ultimately lose the battle.

On composition, Duffy and his research team are studying whether buybacks effectively clean up illiquid "odd lots" of off-the-run Treasuries that clog dealer balance sheets. The original purpose was to replace fragmented holdings with new, liquid securities while potentially profiting the taxpayer through buy-low-sell-high mechanics.

Regarding Fed balance sheet reduction under new Chair Kevin Warsh, Duffy explains the fundamental constraint: the Fed cannot shrink assets without shrinking liabilities dollar-for-dollar. The three liability categories—Treasury General Account, physical currency, and bank reserves—offer limited reduction options. The Treasury won't withdraw from its Fed account, Americans won't turn in cash, leaving only bank reserves. However, modern liquidity regulations and the Fed's payment of market-rate interest on reserves make banks reluctant to relinquish them. Duffy invokes Raghu Rajan's 2017 Jackson Hole ratchet-effect paper, arguing banks become "addicted" to reserves once the Fed expands them, resisting reduction and causing market volatility if forced.

Duffy predicts the Fed task force on balance sheet composition will likely recommend shifting the asset mix toward Treasury bills and away from longer-term securities and mortgage-backed securities, reducing interest expense volatility rather than total size. He argues the Fed should develop tools to control its balance sheet regardless, to maintain independence from Congressional pressure to expand.

On the term premium concept, which Joe Wiesenthal skeptically questions, Duffy explains it decomposes long-term yields into expected short-term rates plus a time-varying risk premium. The premium depends partly on Treasury issuance volume and fiscal trajectory expectations. He references John Cochrane's work on fiscal theory of the price level as relevant to understanding these decompositions.

The conversation touches on broader dynamics: hyperscalers are issuing significant debt (approaching $1 trillion), but Treasury issuance at $31 trillion and rising dominates bond market supply constraints. Foreign buyers have reached saturation, leaving domestic investors absorbing incremental supply at higher yields.