Navigating Fiscal Dominance: Why Inflation-Linked Bonds and Short-Term Strategies Are Critical Now

The bond market's quiet stability is fraying. From the UK's 2022 gilt market crash to the Federal Reserve's decade-long experiment with ultra-low rates, investors are confronting a stark reality: fiscal dominance—the point at which governments' spending needs force central banks to monetize debt—is reshaping financial markets. History shows that when fiscal imprudence collides with monetary accommodation, bond yields spike, inflation surges, and confidence in currencies erodes. Today, with global debt at record highs and central banks constrained by political pressures, the lessons of the past are more relevant than ever.

The Historical Toll of Fiscal Dominance

Fiscal dominance occurs when a government's fiscal needs override a central bank's ability to set independent monetary policy. The consequences are rarely benign.

Take Germany in the 1920s: After World War I, the Weimar Republic faced astronomical war reparations and a shattered economy. With no way to raise sufficient taxes, the government resorted to printing money to finance deficits. . The result was hyperinflation, with prices doubling every few days. Government bond yields became meaningless as the mark collapsed, erasing wealth and destabilizing markets.

Fast-forward to modern cases: Argentina's chronic fiscal deficits and debt monetization by its central bank have fueled inflation exceeding 200% in recent years. Turkey's insistence on politically driven low rates, even as inflation hit 85% in 2021, forced bond yields into a volatile spiral. And in 2022, the UK's Liz Truss administration proposed massive tax cuts and spending without credible funding plans. The market revolt that followed——saw yields spike 100 basis points in days, forcing the Bank of England to intervene.

These episodes share a common thread: fiscal dominance erodes the credibility of monetary policy, pushing investors to demand higher yields to compensate for inflation and default risks.

Current Risks: Fiscal Slack and Monetary Constraints

Today's global economy faces similar pressures. The U.S. federal debt has surged to nearly 125% of GDP since 2020, fueled by pandemic stimulus and a reluctance to meaningfully address deficits. Meanwhile, the Fed has hiked rates to 5.5%—the highest in 22 years—to combat inflation, but political constraints may limit its ability to sustain this path.

The risks are twofold. First, if inflation remains sticky, the Fed could face a choice between raising rates further (risking a recession) or capitulating to political demands to keep rates low—a scenario akin to Turkey. Second, if fiscal deficits grow unchecked, the Treasury's need to issue more debt could force the Fed to monetize it, pushing yields higher and destabilizing bond markets.

The Investment Playbook: Inflation-Linked Bonds and Short Durations

In such an environment, traditional fixed-income strategies—long-dated Treasuries, corporate bonds—face headwinds. Here's why investors should pivot:

1. Inflation-Linked Securities (TIPS, ILBs):
   Bonds like U.S. Treasury Inflation-Protected Securities (TIPS) or UK Index-Linked Gilts adjust their principal for inflation, shielding investors from rising prices. For example, TIPS have outperformed nominal bonds in the past year as inflation remained elevated. . While these securities are not immune to rate hikes, their inflation hedge provides critical downside protection.

2. Short-Duration Bond Strategies:
   Short-term bonds (maturities of 1–3 years) minimize exposure to rising rates. For instance, the iShares 1–3 Year Treasury Bond ETF (SHY) has a duration of just 1.6 years, limiting its sensitivity to yield fluctuations. In contrast, long-term bonds like TLT (duration ~9 years) face steep losses if yields climb further. .

Backtest the performance of the iShares 1–3 Year Treasury Bond ETF (SHY) when buying on the announcement date of Federal Reserve rate hikes, and holding for 30 trading days, from 2020 to 2025.
Historically, this strategy has shown promise: SHY delivered an average return of 3.82% and a maximum drawdown of just -0.50% over 30-day holding periods following Fed rate hikes from 2020–2025, with a Sharpe ratio of 1.89. This underscores the ETF's resilience and risk-adjusted gains during periods of monetary tightening, aligning with its short-duration profile.

Additionally, short-duration corporates and municipal bonds with strong credit ratings can offer higher yields than Treasuries without excessive duration risk.

1. Avoid Long-Duration Debt:
   The risk of a “bond bear market” is real. If fiscal dominance leads to sustained inflation or higher yields, long-term bonds could see historic declines. The 30-year Treasury yield has already risen from 3% in early 2023 to 4.5% today—a 50-basis-point increase that would erase over 10% of the value of a 30-year bond.

Conclusion: Prepare for a New Normal

History is not destiny, but it offers clear warnings. Fiscal dominance has repeatedly ended in market chaos, and today's policy choices could push us toward similar outcomes. Investors must adapt by prioritizing portfolios that withstand inflation and rate volatility.

For now, tilt toward inflation-linked bonds for protection and short-duration strategies to limit interest rate risk. The era of “set it and forget it” bond investing is over. In a world where fiscal imprudence meets monetary limits, vigilance—and the right tools—are essential.

Nick Timiraos is a pseudonym for the author of this article.