The U.S. Bond Market's Underpricing of Political and Fiscal Risks in 2025

The U.S. bond market in 2025 is exhibiting troubling signs of underpricing political and fiscal risks, as evidenced by elevated term premiums and a steepening yield curve. These dynamics suggest that investors are demanding higher compensation for holding long-term Treasuries, yet the broader market may still be underestimating the structural challenges posed by rising deficits, political interference in monetary policy, and the erosion of Treasury market liquidity.

Term Premium Dynamics: A Barometer of Fiscal and Political Uncertainty

The 10-Year U.S. Treasury term premium, a measure of the extra yield investors demand for holding long-term bonds instead of rolling over short-term debt, has surged to 0.82% as of August 2025, its highest level in over a decade [1]. This increase reflects growing concerns about the sustainability of U.S. fiscal policy, including the recent passage of the "One Big Beautiful Bill," which is projected to add $3.4 trillion to the national debt over the next decade [2]. Additionally, the downgrade of the U.S. sovereign credit rating by Moody’s in May 2025 to Aa1 from Aaa—a 14-year low—has further eroded confidence in the country’s fiscal trajectory [3].

Political risks have also amplified term premium pressures. The Trump administration’s push for aggressive rate cuts and its perceived encroachment on Federal Reserve independence have heightened fears of inflation and policy instability [4]. As noted by Goldman Sachs, these developments are contributing to a "twist steepener" in the yield curve, where short-end yields fall due to dovish monetary policy expectations, while long-end yields rise amid inflation and fiscal risks [5].

Yield Curve Positioning: A Steepener as a Warning Signal

The U.S. yield curve has steepened significantly in 2025, with the spread between 2-Year and 10-Year Treasury yields reaching 52 basis points in Q2 2025 [6]. This steepening reflects divergent market expectations: short-term rates are anticipated to decline due to Fed easing, while long-term yields are driven higher by concerns over inflation, fiscal deficits, and political uncertainty. For instance, the 10-Year yield rose to 4.26% in late August 2025, despite dovish comments from Fed Chair Jerome Powell at Jackson Hole, underscoring the market’s skepticism about the Fed’s ability to insulate the economy from fiscal headwinds [7].

Historically, yield curve steepening has often preceded periods of fiscal dominance, where political considerations override monetary policy credibility. A 2025 report by BNP Paribas notes that the U.S. Treasury market’s "idol with feet of clay" is increasingly fragile, with structural factors such as a surge in short-term investors and regulatory constraints on banking intermediation exacerbating liquidity risks [8]. This fragility is evident in the breakdown of traditional correlations, such as the U.S. dollar’s positive relationship with Treasury yields, which has weakened as investors question the safe-haven status of U.S. debt [9].

Underpricing Risks: Lessons from Past Crises

The current underpricing of risks mirrors patterns observed during past fiscal and political crises. During the 2020 pandemic, for example, the Treasury-OIS spread—a measure of Treasury market liquidity—surged to historically positive levels, reflecting severe dysfunction in the bond market [10]. Unlike the 2008 financial crisis, where the spread turned negative as investors flocked to Treasuries, the 2020 episode highlighted how supply shocks and regulatory constraints could destabilize even the most liquid markets.

Similarly, the 2007–2009 crisis demonstrated how yield curve inversions could signal impending recessions, as investors anticipated rate cuts and economic downturns [11]. Today’s steepening curve, however, suggests a different dynamic: rather than signaling a recession, it reflects a loss of confidence in the Fed’s independence and the U.S. fiscal outlook. This divergence underscores the need for investors to reassess traditional risk metrics in light of evolving political and fiscal landscapes.

Implications for Investors

The underpricing of risks in the U.S. bond market has significant implications for asset allocation. As term premiums remain elevated and the yield curve steepens, investors may need to rebalance portfolios to account for higher inflation expectations and fiscal uncertainty. Gold and other inflation-linked assets have gained favor, as lower short-end yields reduce the cost of holding non-yielding assets [12]. Meanwhile, long-term Treasuries, once a cornerstone of safe-haven demand, are increasingly viewed as vulnerable to a repricing of risk, particularly if deficits exceed 6% of GDP—a threshold that could trigger a broader market reassessment [13].

For policymakers, the challenge lies in restoring confidence in both fiscal and monetary frameworks. Without credible deficit reduction measures or a clear separation of political influence on monetary policy, the U.S. bond market’s underpricing of risks may persist, with long-term consequences for global financial stability.

Conclusion

The U.S. bond market’s current dynamics—elevated term premiums and a steepening yield curve—serve as early warning signals of underpriced political and fiscal risks. While investors are demanding higher compensation for long-term Treasuries, the broader market may still be underestimating the structural challenges posed by rising deficits, political interference, and liquidity constraints. By drawing parallels with historical crises, it becomes evident that the underpricing of these risks could lead to significant repricing events, necessitating a proactive approach to portfolio management and policy reform.

Source:
[1] U.S. Treasury Term Premiums [https://www.frbsf.org/research-and-insights/data-and-indicators/treasury-yield-premiums/]
[2] Fiscal Dominance in the US—Will Politics Trump Policy? [https://www.westernasset.com/us/en/research/blog/fiscal-dominance-in-the-us-will-politics-trump-policy-2025-08-25.cfm]
[3] The Decline of the US Treasury Premium [https://www.nber.org/digest/202509/decline-us-treasury-premium]
[4] How Trump's Policy Risk Is Showing in Treasury Bonds [https://www.reuters.com/markets/rates-bonds/how-trumps-policy-risk-is-showing-treasury-bonds-2025-04-08/]
[5] Steepening US Yield Curve and What It Means for Gold [https://www.home.saxo/en-sg/content/articles/commodities/steepening-us-yield-curve-and-what-it-means-for-gold-28082025]
[6] Q2 2025 Quarterly Market Review [https://www.td.com/us/en/investing/learning-and-insights/quarterly-market-review-q2-2025]
[7] Weekly Fixed Income Commentary | 08/25/2025 [https://www.nuveen.com/en-us/insights/investment-outlook/fixed-income-weekly-commentary]
[8] The US Treasuries Market: An Idol with Feet of Clay [https://economic-research.bnpparibas.com/html/en-US/US-Treasuries-Market-Idol-Feet-Clay-US-Federal-Debt-Risks-Abundance-8/29/2025,51796]
[9] The Rise in Long-Term US Treasury Yields [https://www.brookings.edu/articles/the-rise-in-long-term-us-treasury-yields/]
[10] Treasury Inconvenience Yields During the COVID-19 Crisis [https://pmc.ncbi.nlm.nih.gov/articles/PMC9759744/]
[11] Yield Curve Inversions: What They Really Tell Us About Economic Cycles [https://verifiedinvesting.com/blogs/education/the-yield-curve-phenomenon-what-inversions-really-tell-us-about-economic-cycles?srsltid=AfmBOopMBBYrUZe2S_jlh1lGfwS6fACt8x1k8sxyi4_Dte7sLCKB80kO]
[12] Steepening US Yield Curve and What It Means for Gold [https://www.home.saxo/en-ch/content/articles/commodities/steepening-us-yield-curve-and-what-it-means-for-gold-28082025]
[13] Macro & Strategy - August 2025 [https://iagam.ca/insights/macro-strategy-august-2025]