May 26th, 2025 - The "bond vigilantes" are circling the US market.

In the wild west, the vigilantes took enforcement of the law in their own hands, due to the absence or the inability of authorities to prevent crime. Of course, running a large fiscal deficit while being heavily indebted is not a crime per se, but rather a reckless behavior on the part of a government, with serious future consequences on the citizens and the country. Most investors can accept the short-term need for a country to surpass the accepted limits of debt and deficits in case of emergencies (Covid) or to stimulate the economy during a recession. Especially when we are talking about a major country, like the US, international creditors will continue lending their euros, pounds and francs, as liquidity has to be placed somewhere and the status-quo cannot easily be challenged.

The "bond vigilantes" do not really care about the status-quo. Just as the 1850s vigilantes sometimes were nothing but mobs who, masked as good-doers, all they wanted was to capture power and wealth, the bond vigilantes want to make profits regardless of how. When they see the opportunity in a country (high debt, high deficits, weak leadership), they will start short-selling aggressively its bonds, driving up the interest rates at which the country must borrow to finance its deficit. As yields spike the country enters a vicious downward spiral, because not only it has a lot of debt and a budget deficit, but the cost of servicing that debt is increasing, and hence the fiscal situation is worsening further, because the markets are moving against it What can start as a speculative trade by a few players/vigilantes can lead to a larger part of the investment community deciding to slow or even stop lending to that government, let alone to sell their holdings too. Ultimately and when capital completely dries up, there is only one option: print money and/or default on the debt obligations. Countries like Argentina and Greece can definitely share their story in this context.

If you think that markets do not have such power with larger countries, we can offer some recent examples and some not so recent ones. The UK lost a Prime Minister who served only for two months in the fall of 2022 (Liz Truss) and who made the mistake to underestimate how the markets will react when she proposed tax cuts and more debt, to cover the cost of high inflation for its citizens. The sell-off in UK government bonds led to her resignation within hours. President Trump took back his aggressive reciprocal tariffs on April 4th, just two days after his announcement, because the world was abandoning the US debt and the dollar. The relentless selling of US bonds made interest rates shoot up by a whopping 0.5% in a matter of 72 hours, in what Trump called "the bond market got a little queasy". In the 1980s, which is also when the term "bond vigilantes" first appeared, the sell-off in US government bonds led to major changes in the FED and that was when Paul Volcker finally became Chairman and took such extreme measures that pushed the economy into a deep recession. But he saved the country's ability and credibility to borrow from international creditors.

The US government bond market has been nervous since President Trump took office, in mid-January. Not only high tariffs were seen as inflationary and hurting economic growth (stagflation), but they also hurt relationships with long standing allies who are creditors to the US government. Then came the recent reconciliation bill that is poised to make the 2017 tax cuts permanent, and which was passed by the House last week with a very thin majority (215-214). Tax cuts are usually a great fiscal tool for the economy , as they boost personal and corporate income and free up capital for investments or spending. But they are also lowering a government's revenues, and when that country is already spending at the highest level vs GDP in its history (aside war periods) , it is natural for bond investors to start feeling uneasy, at best.

The bond market will continue to be a source of volatility for markets and accidents could happen down the road. As a reminder, some regional banks in the US failed in 2023 because of the spike in bond yields, and smaller companies might face trouble financing their daily operations, leading to a spike in bankruptcies. We have a clear preference for high quality (single A and above) bonds at this stage. Last week, the 30yr US Treasury yield reached 5.15% the highest level since 2023, which was when inflation was very high and the FED was aggressively raising rates. Byers finally emerged and the yield dropped to slightly above 5%. The German 10yr yield reached a high of 2.65%, as markets are correlated, and EUR bonds are back in buying levels, after spending the previous weeks in much lower yields, which we thought were unattractive to chase.

The Eurozone PMI in May showed a big difference between the Services and the Manufacturing industries. The Composite number fell by 0.9 points to a 6-month low of 49.5, below consensus of 50.6 and is now back below the growth threshold (50) for the first time since December 2024. While weaker business sentiment is in line with the expectations for slowing activity, the details were somewhat surprising. Specifically, the decline was exclusively driven by the Services PMI, which retreated 1.2 points to 48.9 to its weakest level since January 2024. By contrast, the Manufacturing PMI ticked up for the fifth consecutive month to 49.4, despite trade uncertainty. Most strikingly on the positive side, one-year ahead business expectations in manufacturing rose strongly by 3.2 points to 61.2 - the highest level in three years. By contrast, expectations deteriorated in services to a 2.5 year low.

Global equities fell for a straight second week. The impressive rebound from the early April lows has stalled for now, which can be viewed as normal. The volatility in the bond market and the on-going tariffs theme which is not getting any better left their marks on equities with US indices falling about 2% on average and Europe finishing 1% lower on average.

Chart of the Week : Another false alarm or recession is around the corner ?

The below chart shows the difference in the interest rates between the 10yr and 2yr US Treasury bonds. A normal yield curve is when the longer term interest rates are higher than the shorter term, which means that this difference is positive. Very rarely this difference approached zero as in early 2007 and 2019 or even negative in 2022 when the FED started raising interest rates aggressively and the longer term yields were slow to react. In all these instances the yield subsequently "steepened", or in simpler words the difference became positive and moved much higher. However, in those instances the economy fell into a recession eventually, as is shown with the grey areas. This same steepening is happening since mid-2023, leading many economists think that a recession was about the corner in 2024. Of course, this never materialized because the AI boom as well as the huge US government spending provided stimulus into the economy. What will happen in 2025 is anybody's case and it could be that this is another false alarm (or not).

Disclaimer

• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.

• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.

• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.

• This document is strictly confidential and should not be distributed further without the explicit consent of Kendra Securities House SA.

• Sources: Chart of the Week : FactSet