Last week proved to be challenging for US Treasury bonds, which are the government’s IOUs used to fund federal spending that exceeds tax revenues.

As noted by Dominic O’Connell on Saturday, Treasury yields surged following Moody’s downgrade of America’s credit rating, marking it as the last major rating agency to do so. This comes as Donald Trump’s proposed bill progresses, projected to increase government borrowing by an estimated $3 trillion to $4 trillion over the next ten years.

Another significant factor behind the sell-off was the weak interest in a $16 billion auction of 20-year Treasuries on Wednesday, signaling some investors’ hesitance to lend to the government. Investors asked for a 5 percent coupon (interest payment) due to the perceived risk.

What stands out in the Treasury movement is the specific areas on the yield curve (which charts bonds of similar credit quality with varying maturities) where major shifts occurred.

Throughout the week, the yields on both two-year and five-year Treasuries remained relatively stable, while the longer end of the curve experienced considerable sell-off. The yield on ten-year Treasuries increased by 0.071 percentage points, reaching 4.509 percent, and the 30-year Treasuries, known as the long bond, saw the most significant rise of 0.141 percentage points to 5.05 percent, marking a rise to levels not observed since October 2023.

This rise in the long bond’s yield, typically viewed as a secure investment, is crucial because it influences borrowing costs for households and businesses across the US. Market analysts are now concerned as these yields approach levels experienced at the beginning of the global financial crisis in 2007.

The widening gap, referred to as “yield curve steepening,” represents a crucial development.

While yield curve steepening could indicate potential economic growth, in this scenario, it signals worries about inflation.

David Sadkin, president of Bel Air Investment Advisors, stated to The Wall Street Journal last week, “The bond market is indicating that inflation remains a serious risk to the economy… this marks the highest level of uncertainty I have witnessed in at least 17 years, reminiscent of the financial crisis.”

Yield curve steepening is a trend not limited to the US, as it is also observed in several advanced economies, including Germany, Japan, and the UK. At the close on Friday, the yield on 30-year German bonds, which was negative at the end of 2021, reached 3.111 percent.

This steepening trend varies across countries but shares several common factors, as noted by Ralf Preusser and Sphia Salim, rates strategists at Bank of America, in their report, Big Bang Bond Steepening.

They highlighted, “Common global drivers of this trend are: elevated government financing requirements; decreasing central bank balance sheets (which intensifies the effect of rising government bond supply) and declining duration demand from liability-driven investors.”

This has significant implications for how countries like the UK approach borrowing in bond markets in the future.

The UK, with a longer average debt burden compared to many peers, is likely to experience higher costs for servicing its debts as the yield gap widens.

Several factors contribute to the steepening in the UK, including a reduction in defined benefit pension scheme deficits from a peak of £2 trillion and fewer retirees drawing income from such schemes. The Bank of America team emphasized that many of these schemes are rapidly aging. Membership in defined benefit plans fell by 16 percent from the third quarter of 2019 to the first quarter of last year. The decline is largely due to the phasing out of such schemes for new members following a controversial tax strategy by former Chancellor Gordon Brown in 1997.

Additionally, the assets held by these pension schemes are primarily concentrated in gilts, the UK’s government bonds.

This situation could potentially reduce the demand for longer-dated gilts that pension schemes traditionally purchase to fulfill future liabilities, a strategy referred to as Liability Driven Investing (LDI) that greatly influenced the turmoil in bonds after former Chancellor Kwasi Kwarteng’s mini-budget in September 2022.

The Bank of America team suggested that the Debt Management Office (DMO), responsible for gilt issuances, might reduce the average maturity of these securities, possibly aided by the Bank of England’s adjustments during its unwinding of bond portfolios acquired through quantitative easing.

Mark Capleton, the UK rates strategist at Bank of America, has proposed several measures. Notably, he suggested that the DMO could halt and eventually suspend the issuance of long-dated gilts.

This approach echoes the strategy of Sir Geoffrey Howe, often regarded as Britain’s most effective post-war Chancellor, who implemented similar measures in the early 1980s to lower long-term borrowing costs while simultaneously stimulating activity in corporate bonds, which had been overshadowed by significant government borrowing.

Such a strategy, if revived, could similarly invigorate the market and foster increased risk-taking, particularly in long-term infrastructure projects, which would be welcome news for Rachel Reeves, the current Chancellor.

Ian King is a presenter for Sky News. Ian King Live airs from 10.00-11.00, Monday to Friday.