Donald Trump’s retreat, as many mainstream media outlets have pointed out, was not so much driven by the bloodshed on Wall Street as by the reaction of the so-called “punishers” of the bond market (please read also the analysis titled “Tariffs and the $3 trillion held by Asian central banks that make them punishers in the US bond market“).
Rising borrowing costs are pushing up debt service costs, which have topped $1 trillion by fiscal year 2024 and are on par with defense and Medicare spending—the fiscal mismanagement and bond market fury are the only things Trump would not want to face at a time when he is negotiating tariffs with countries around the world.
Investors’ repeated experiences of being on the wrong side of the Federal Reserve’s (bottomless) balance sheet have led to a now-familiar maxim: “Don’t fight the Fed.”
This is still an accurate picture of how the Fed can affect asset prices when it chooses to intervene, but what does it mean in the context of the complex market environment we are currently experiencing?
In 2025, investors should not even be up against the Treasury. The U.S. Treasury is not usually the subject of this kind of investment wisdom, and there are certainly reasons for this.
While the central bank can mobilize resources with great speed in an emergency, the more bureaucratic Treasury usually takes time to change policy direction. But the current massive bond sell-off is blurring the distinct lines between a crisis situation and normal market operations in ways that should make investors brace for unusual policy responses.
Investors should not underestimate the tools the U.S. government has at its disposal to influence asset prices, independent of the Fed. Treasury Secretary Scott Bessent has said his focus is on keeping 10-year Treasury yields low. Those yields have been volatile and have risen about 40 basis points since early April.
Bessent’s Three Tools
Bessent can use three tools in particular to reduce long-term Treasury yields:
1. banking regulation – The SLR Index
2. bond issuance, and
3. tax policy
Treasury regulation, particularly of the banking system, can have a significant impact on interest rates. Bessent has highlighted this potential by referring to the “Supplementary Leverage Ratio” (SLR) in recent public appearances.
1. The SLR defines the minimum amount of capital that banks are required to hold, relative to their total assets plus off-balance sheet adjustments, which include so-called risk-free assets, such as U.S. Treasury bonds. The Federal Reserve is formally responsible for overseeing the implementation of the SLR, but the Treasury Department has some say in it.
Bessent also has an ally in Fed Governor Michelle Bowman, who is awaiting Senate confirmation as the Fed’s vice chair for banking supervision. Bessent argues (and Bowman agrees) that the SLR should exclude government-guaranteed securities from banks’ asset totals because they carry no credit risk.
Removing government bonds from SLR capital calculations would create new bank demand for government bonds, and would lead to a corresponding decline in yields. Bessent estimates that some yields could fall by between 30 and 70 basis points if the exemption were implemented.
However, banks are still concerned about matching the duration of their assets to their liabilities, which are typically quite short-term. So the biggest beneficiaries of the SLR reform are likely to be short-term government bonds and government-backed mortgage-backed securities. These assets are tied to short-term returns, rather than the 10-year yield that Bessent is targeting.
2. With its focus on long-term yields, the Treasury will likely draw on its debt issuance capabilities.
Before the election, Bessent criticized his predecessor, Janet Yellen, for not issuing more long-term Treasury bonds when yields hit historic lows in the wake of the Covid-19 health crisis. But since taking office, the timing of debt issuance has not changed.
The yield on the 30-year Treasury note rose about 30 basis points in April, and in light of that, Bessent may be considering issuing fewer bonds at the long end of the yield curve.
(Note that the Bank of England recently decided to stop issuing long-term bonds until July, or at least until market volatility subsides.) In 2023, Yellen has begun a process of buying back some older Treasury bonds in order to smooth out mispricing across the entire yield curve.
Bessent could use this opportunity to issue short-term Treasury bills to buy longer-term securities. Such a program would be a fiscal version of the Fed’s 2012 “Operation Twist,” which attempted to flatten the yield curve using monetary policy.
3. Tax policy also gives the Treasury Department an opportunity to influence bond yields. Republicans in Congress say they want to push a tax bill through a fast-track process by the summer.
The administration could use this opportunity to change laws to encourage U.S. households to increase their exposure to Treasury bonds. A bill could, for example, exempt domestic bondholders from the tax—a move that would likely significantly reduce Treasury yields, offsetting any potential revenue loss.
Tax policy could also encourage or require U.S. pension funds to hold a certain portion of their assets in Treasury bonds, a practice common in many countries. Such an active suppression of Treasury yields would have drawbacks.
In particular, it could further weaken the dollar as non-U.S. investors seek higher returns elsewhere. This could achieve the Trump administration’s goal of rebalancing bilateral trade relations without some of the economic and market distortions that have resulted from tariffs.
Although the Trump administration has, so far, maintained a verbal commitment to a strong dollar, some officials have discussed the burden it places on the U.S. manufacturing sector as the global reserve currency.
Much of the recent sell-off in the bond market has been driven by concerns about who will continue to finance the federal budget. The U.S. Treasury may not have much leverage over foreign creditors if they choose to avoid U.S. bonds at current yields.
But it does have tools to incentivize domestic institutions and households to buy bonds. Investors should not side with the U.S. Treasury if it does intend to lower bond yields. The bets are on – whether this will remove the bond market’s “punishers” remains to be seen.
