1. Deficits and debt
A deficit is the gap between what a government spends and what it collects in a year. The debt is the sum of past deficits. Governments cover deficits by selling bonds: short-term bills and longer notes and bonds. The US Treasury announces how much it plans to sell each quarter in its "refunding" statement, which bond investors read closely.
- US federal deficit, 2024
- ~6% of GDP
- About $1.8 trillion
- US debt held by the public
- ~100% of GDP
- Up from about 35% in 2007
- US net interest cost, 2024
- >$850bn
- More than defence spending
2. How borrowing reaches yields
More supply
Selling more bonds means finding more buyers. If demand from pension funds, foreign investors, banks and the central bank doesn't keep up, prices have to fall (yields rise) until enough buyers step in. Quantitative tightening adds to the supply private investors must absorb, because the central bank is no longer buying.
More risk
Investors also worry about what large deficits might lead to: higher inflation, pressure on the central bank to keep rates low, or in extreme cases doubts about repayment. All of these raise the compensation they ask for, the term premium.
Crowding out
When government borrowing pushes up interest rates, it can make borrowing dearer for companies and households too, reducing private investment. Economists call this crowding out.
3. The term premium
The term premium can't be seen directly; economists estimate it with models, such as one published by the New York Fed. Those estimates put the US 10-year term premium below zero for much of 2016–2021, when the Fed was buying bonds and inflation was low. It turned positive in 2023 as inflation uncertainty, heavy borrowing and QT pushed long yields up.
Case study: the US bond sell-off of 2023
In August 2023 the Treasury raised its borrowing estimates and Fitch downgraded the US credit rating from AAA to AA+. Over the next three months the 10-year yield rose from about 4% to almost 5%, its highest since 2007, even though the Fed did not raise rates again. Much of the move was attributed to a rising term premium rather than expectations of higher Fed rates.
4. When bond markets push back
The term bond vigilantes, coined by economist Ed Yardeni in the 1980s, describes investors selling government bonds to protest at fiscal or monetary policy. In the 1990s, President Clinton's adviser James Carville joked that he wanted to be reincarnated as the bond market, because "you can intimidate everybody".
Case study: the UK mini-budget, September 2022
The UK government announced about £45 billion of unfunded tax cuts without an independent forecast of the public finances. Gilt yields jumped by more than a percentage point within days, sterling fell to a record low against the dollar, and pension funds using leveraged LDI strategies were forced to sell gilts. The Bank of England stepped in, most of the tax cuts were reversed, and the Prime Minister resigned after 49 days in office.
Why debt levels alone don't decide
Japan's government debt is more than twice the size of its economy, far higher than the US or UK, yet for decades it paid some of the lowest yields in the world. Most of its debt is held at home, by Japanese savers, banks and the Bank of Japan, and inflation stayed low. What matters is whether investors trust the plan, who holds the debt, and the outlook for inflation.
5. What analysts watch
- Quarterly refunding announcements and the size of upcoming auctions.
- Auction results: weak demand (a low bid-to-cover ratio, or a yield above what the market expected) can move the whole curve.
- Credit rating changes: Moody's removed the last US AAA rating in May 2025.
- Budget forecasts from independent bodies such as the US Congressional Budget Office or the UK's Office for Budget Responsibility.
- Estimates of the term premium, and the gap between long and short yields.
Key takeaways
- 1A long-term yield = expected short-term rates + the term premium.
- 2Larger deficits mean more bonds to sell; if buyers need more persuading, the term premium rises.
- 3Debt levels alone don't set yields: Japan borrows more than the US relative to its economy and pays far less.
- 4Credibility matters most: the 2022 UK mini-budget showed how fast markets can punish unfunded plans.
- 5Rising interest costs can feed on themselves, which is why investors watch deficits even in good times.
Related
Educational content only. It describes how markets have behaved in the past and is not investment advice.