Why Treasuries Became Risky Again

In this episode of the OddLots podcast, Tracy Allaway and Joe Weisenthal interview Carolyn Pflueger, an associate professor at the University of Chicago Harris School of Public Policy, to discuss why treasury yields have become elevated and risky. The conversation begins with observations that the 30-year treasury yield has reached 5.59%, the highest level since 2002, despite recent Fed rate hikes that were supposed to dampen financial conditions.

Pflueger explains her research on the Fed's perceived policy reaction function—what markets expect the Fed to do in response to economic conditions. She describes two methodologies for measuring this: analyzing forecaster surveys about the Fed funds rate relative to inflation and output expectations, and observing how yields react to macroeconomic data releases. A key finding is that between 2021 and early 2022, markets perceived an extremely flat policy reaction function, expecting zero interest rates even as inflation hit 5-6%, suggesting market participants didn't believe the Fed would respond meaningfully to inflation. Only after the Fed actually began raising rates in March 2022 did markets update their perceived policy reaction to inflation, rising from zero to approximately one by late 2023. Pflueger calls this the "learning from actions" channel—markets learn about Fed credibility through actual policy moves, not just communication.

The discussion then shifts to bond market risk. Pflueger notes that treasury bonds were not always considered safe assets historically. During the 1970s-1990s, they were viewed as risky and moved together with stocks (positive correlation). Post-2000, through roughly 2020, treasury bonds exhibited negative correlation with stocks, making them effective portfolio hedges. However, in recent years, bond-stock correlation has turned positive again, making bonds riskier. Using UK inflation-indexed bond data, Pflueger finds that pre-2000 bond risks were largely driven by inflation concerns (stagflation fears), while post-2000 risks were driven by real economic factors, as recessions became primarily demand-driven rather than supply-driven.

On quantifying what's driving current yields, Pflueger presents research with Matteo Lombroni and Adi Sundaram showing that roughly one-quarter of the decline in 10-year yields from the 1980s to 2010s was due to treasuries becoming safer assets (better hedges). Conversely, over the past five years (2020-2025), the majority of the yield increase can be explained by treasuries becoming more stock-like and therefore riskier, while inflation expectations have remained relatively stable. This suggests investors require higher compensation for holding risky bonds.

When asked what would restore bonds' status as safe assets, Pflueger identifies two components: luck (the nature of economic shocks) and policy (monetary policy credibility and gradualness). She explains that the Great Moderation of the 1990s-2000s resulted partly from good luck (fewer supply shocks) and partly from policy credibility that allowed the Fed to implement gradual, data-dependent rate adjustments. A return to 1980s-style risky bonds would require a "perfect storm" of supply shocks (like oil price spikes) combined with a Fed forced to accept recessions, which seems unlikely given current policy frameworks.

The conversation broadens to geopolitical dimensions of bond market safety. Pflueger references historical examples—Hamilton's recognition that bond market depth was essential to U.S. liberty, and Britain's low borrowing costs during the Napoleonic Wars that reinforced its military dominance. She presents research with Pierre-Olivier Red on how financial market capacity and military hegemony interact, showing that deep bond markets can create a positive feedback loop: lower borrowing costs enable military and economic investment, which justifies investors' confidence, perpetuating the cycle. Notably, she suggests hegemonic transitions could theoretically occur through financial markets alone, without military conflict, if markets lose confidence in one hegemon and shift to another.

Joe raises the stark contrast between U.S. 30-year yields at 5.59% and Chinese 30-year yields at approximately 2%, suggesting this spread could reflect market expectations about relative economic strength and credibility. Pflueger notes her framework distinguishes between three explanations for yield changes: declining natural rates (productivity growth), changing demand for safe assets, and changing safety of treasuries themselves. Her research demonstrates the third factor is substantial.

The discussion concludes by touching on the role of fiscal policy and bond supply. While acknowledging that large deficits require funding, Pflueger emphasizes that in a closed economy framework, fiscal expansion simply redistributes existing capital. The key question is whether investors who receive fiscal proceeds will buy bonds or deploy capital elsewhere (stocks, boats, etc.), but ultimately the market prices in the risk profile of the assets themselves rather than mechanical supply arguments.