03-07-2025
Why are bond vigilantes holding back their fire?: Panizza and Gulati
(The opinions expressed here are those of the authors, professors at the Geneva Institute and the University of Virginia.)
A core tenet of sovereign debt investment is that strong institutions keep down a country's borrowing costs and vice versa. So then why has the bond market's response to U.S. President Donald Trump's institutional norm-busting been so tame?
Sovereign borrowers are hard to sue and harder still to enforce claims against. And because they are sovereign, they can do things that private companies can't, like pass laws and inflate their currencies. Investors, and particularly foreign investors, therefore, should naturally be wary of lending to sovereigns.
And yet, in many cases, they do. For example, roughly a third of U.S. Treasuries were held in foreign hands as of March.
Why take the risk? The answer given by academic theory is that investors typically lend to sovereign borrowers when the country has institutions in place to protect against the threat of expropriation. Conversely, if a country's institutions are weak, or weakening, creditors will significantly increase the sovereign's borrowing costs to compensate for the rising risk.
The classic academic article on this topic was written by Douglas North and Barry Weingast in 1989. It considered the issue by examining constitutional arrangements in 17th century England.
The country was able to borrow significantly more, they argued, after putting in place effective institutions intended to assure investors that parliament could, and would, check the monarch's temptation to expropriate. And that, in turn, helped England become a global superpower, North and Weingast said.
A large literature has subsequently been built on this paper. Scholars have hypothesized - and shown - that having institutions that can constrain an overreaching sovereign, such as a strong and independent judiciary, central bank and press, do indeed help keep down borrowing costs.
That is why the countries that carry the biggest risk premia in debt markets, such as Belarus, Lebanon, and Sudan, are far from models of institutional stability.
TRUMP PREMIUM?
So what about the United States? Since January, Donald Trump's administration has challenged many domestic institutional norms long considered key constraining mechanisms on the executive. This has included confrontations with judges, legislators, the central bank, bureaucrats, academics, protesters, law firms and even provisions of the U.S. Constitution itself.
And then there are the numerous international agreements the administration has backed out of or undermined, including the Paris Agreement on climate change and the World Health Organization. Moreover, the announcement of broad-based 'reciprocal tariffs' challenges the foundation of the modern trade system as regulated by the World Trade Organization.
Put all of the foregoing together, and we would have expected to see a significant move upward in U.S. Treasury yields.
But that hasn't happened.
There have certainly been some signs of discontent among bond investors, including after Trump's "Liberation Day" tariff announcement and following his musings that Federal Reserve Chair Jerome Powell's termination 'cannot come fast enough.'
In both cases, the bond market moves were notable but not earth-shattering. They did appear to have the desired effect, as the administration responded by either softening its language or postponing controversial policies, and these pivots led to market recoveries. But given the stakes, jumps of less than 75 basis points in the 10-year Treasury yield seem rather contained.
It's also true that the term premium on the 10-year U.S. Treasury note – a measure of compensation investors demand for holding longer-dated U.S. government debt – hit a 10-year high in May, though that's far from elevated by historical standards.
BOND VIGILANTES?
Why are the infamous bond vigilantes holding back?
There are several possible explanations.
First, the theory about the link between institutional strength and borrowing costs could be wrong. Things like the rule of law and central bank independence are nice to have, but, ultimately, bondholders care about one thing: getting paid.
And the risk of a U.S. default remains low. While investors have been getting antsy about the potential for Trump's One Big Beautiful Bill to add around $3.3 trillion to the deficit over the next decade, according to the Congressional Budget Office, the dollar remains the world's reserve currency, so the U.S. has more room for fiscal profligacy than most.
Indeed, U.S. Treasuries' long-held role as the global risk-free asset may be why yield spikes have been contained. The $28 trillion U.S. Treasury market remains a key pillar of the global financial architecture, and there is no ready substitute with the same size, liquidity and depth.
So it's understandable why investors are loath to flee. No one wants to pull the alarm if there is a significant risk that doing so will cause a part of the building to fall on one's head.
But 'too big to fail' is a short-run story. If the current global risk-free asset isn't living up to its name, substitutes will emerge. In fact, there is already talk of increased debt issuance in Europe offering investors a risk-free alternative.
Moreover, today's bond market indifference may encourage the Trump administration to continue pursuing policies that challenge U.S. institutions and, in turn, undermine long-run growth and weaken the global rules-based economic system it once led.
And if that occurs, North and Weingast's theory could yet play out, and the cost of U.S. borrowing could rise meaningfully.
As economist Rudiger Dornbush famously said, 'In economics, things take longer to happen than you think they will, and they happen faster than you think they could.'
(The views expressed here are those of Ugo Panizza and Mitu Gulati, professors at the Geneva Institute (International Economics) and the University of Virginia (Law). These are their views and not those of their institutions).
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(Writing by Ugo Panizza and Mitu Gulati; Editing by Anna Szymanski and Christian Schmollinger)
