Why Treasuries Are 'Risky' Again

Carolin Pflueger · University of Chicago

A full return to 1980s-style risky Treasuries requires a perfect storm of inflationary supply shocks and a Fed accepting recession.

Recent bond-stock co-movement resembles the 1980s, but the increase is smaller so far, and more of it sits in real (TIPS) bonds rather than inflation. A full return to 1980s-style risky Treasuries needs a perfect storm: inflationary supply shocks (oil, fiscal credibility loss, moving inflation expectations) combined with a Fed forced or willing to accept a recession. Since 2000, the Fed's credibility and more gradual, inertial rule have allowed softer landings, which limits the risk.

“It really requires a perfect storm to go back to the 1980s risky bond markets. It requires the inflationary shocks... and you need a Fed that's willing or forced to accept a recession when these shocks happen.”at 27:50

Carolin Pflueger · University of Chicago

US Treasuries have become much riskier over five years because they now co-move with stocks, demanding higher required returns.

Treasuries have become much riskier over the past five years because they now co-move positively with stocks, so yields rising often coincides with equities falling and investors have 'nowhere to hide' (as in 2022). Because the asset is riskier, investors should demand higher returns, which pushes yields up and prices down. She frames this as a return toward 1980s-style risky bond markets, though not yet as extreme as then, since the Fed has been able to move more gradually.

“If I look at the past five years, what has changed, I think, is that Treasury bonds have become a lot riskier. That's the bond stock movement that I just talked about that has gone up a lot.”at 29:55

Carolin Pflueger · University of Chicago

Most of the 2020-2025 rise in the 10-year Treasury yield reflects bonds becoming stock-like, not higher inflation expectations.

Her research with Umbroni and Sundaram finds that expected returns priced into bond markets track bond-stock co-movement closely. A back-of-envelope calculation attributes about a quarter of the 1980s-to-2010s yield decline to bonds becoming better hedges, and the majority of the 2020-2025 rise in the ten-year yield to bonds becoming more stock-like. Long-term inflation expectations have been stable, so the yield rise reflects increased required compensation for risk rather than higher inflation expectations.

“Over the past five years... the increase in the ten year yield was really the majority... you can explain with changes in bonds becoming more stock like... bond yields going up then reflect increasing risks and increasing required compensation for risks.”at 33:18

Carolin Pflueger · University of Chicago

Declining safety of Treasuries themselves is a substantial driver of changing bond yields, alongside natural rate and safe-asset demand.

Her research finds that the decline in the safety of Treasuries themselves is a substantial driver of changing bond yields, alongside the natural rate and safe-asset demand. Bonds have become riskier, and the stock-bond co-movement now prices that risk. Keeping bonds 'bond-like' depends on central bank credibility and a gradual policy path; the 2021-22 episode combined 1980s-style supply shocks with inertial 2000s-style policy.

“the change in the safety of treasuries themselves is a substantial component. That doesn't mean that the other aspects don't matter, but there's certainly something to the changing riskiness of treasury bonds.”at 42:48

Carolin Pflueger · University of Chicago

Markets learned the Fed's inflation reaction function from its actions, only pricing a real response after hikes began in 2022.

Her measurement of the perceived policy reaction function shows that in 2021 markets expected rates to stay near zero regardless of inflation, even after a huge May 2021 inflation surprise left the two-year yield unchanged. The perceived inflation response only rose from zero to one between early 2022 and late 2023, after the Fed started actually hiking, which she calls 'learning from actions.' Markets understand the Fed's reaction function mainly through its actions, and that understanding helps transmit policy faster.

“The perceived inflation response really picks up. It basically goes from zero to one between, say, early twenty twenty two towards the end of twenty twenty three... it occurred late and only after the Fed had started to act. So we call that the learning from actions channel.”at 16:49

Carolin Pflueger · University of Chicago

Gradual, priced-in Fed policy backed by credibility keeps Treasuries bond-like, but only if that trust persists.

Her models say a gradual approach to monetary policy that is priced in, backed by trust that the central bank will eventually do what is needed, keeps bonds bond-like. This is a conditional point: it holds only if credibility persists. She also found that adding financial-conditions forecasts such as the Baa spread barely changed the Fed's perceived reaction function to the macroeconomy.

“If the trust is there that eventually the central bank will do what is needed, then that's something that... in my models, is something that can keep the bonds bond like.”at 38:35

Carolin Pflueger · University of Chicago

At very high debt-to-GDP, self-fulfilling market expectations could trigger a hegemonic transition away from US Treasuries without war.

Historically, deep bond markets and military power are interlinked, as with the UK in the Napoleonic Wars and the US after WWII. In her model with a coauthor, a tipping point exists, and at very high debt-to-GDP levels financial-market expectations can become self-fulfilling and produce a hegemonic transition without war. She frames this last case as a hypothetical, not a forecast.

“there could be a hegemonic transition that doesn't even involve war. It's just financial markets deciding and pricing in their expectations.”at 48:08

Carolin Pflueger · University of Chicago

Treasury supply matters little to first order due to Ricardian equivalence; bond risk is priced mainly via stock co-movement.

Bond supply matters little to first order because of Ricardian equivalence: taxpayers are also bondholders, so money moves from one pocket to another. Her research suggests bond risks are priced mainly against stock-market co-movement, though she allows that specific bond-market exposure of investors probably also matters. She concedes the real world violates the theory but calls it a useful first approximation.

“We're all taxpayers and to the extent that we're also holding bonds... it's just, you know, going from one pocket to the other. Of course, the real world is a lot more complicated.”at 51:10

Carolin Pflueger · University of Chicago

Stable average long-term US inflation expectations mask rising uncertainty, shown by higher volatility and nominal-real bond delinking.

The point estimate of long-term inflation expectations has stayed relatively stable, but volatility has risen and nominal and real bonds have delinked, unlike before 2000 when their correlation was very high. She reads this as a sign of more underlying inflation uncertainty even though average priced-in inflation looks stable, so the stability is only partial comfort.

“even though on average... the average and long term inflation that's priced in looks very stable. You know, we have seen changes that are probably related to more uncertainty.”at 40:45