Editor’s Note: Wall Street is bracing for the return of an old foe: the bond vigilantes. These market enforcers, a shadowy coterie of traders and investors, are hitting the trail again.

Their mission? To warn of inflationary chaos and fiscal irresponsibility should Donald Trump implement his proposed cocktail of corporate tax cuts and protectionist tariffs. Here’s a closer look at what the bond market is trying to tell us, and how to trade accordingly.

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Rising Yields Amid Optimistic Inflation Data

The bond market reflects investor sentiment about inflation, interest rates, and overall economic health. Movements in bond yields often signal expectations for future growth or recession, providing valuable insights for policymakers and investors alike.

Despite recent readings that suggest inflation is taking a backseat for now, bond yields have been marching upward, punctuated by bouts of unsettling volatility.

The 10-year U.S. Treasury yield, a bellwether of Wall Street’s economic outlook, has been trending higher. Why? Because the bond market, that hyper-sensitive oracle of financial stability, smells trouble on the horizon.

The 10-year yield influences borrowing costs for mortgages, corporate bonds, and other loans, making it pivotal for both consumers and businesses.

Changes in the yield reflect the waxing and waning of investor confidence. A rising yield often signals optimism about economic growth, while a declining yield may indicate concerns about a slowdown. However, with growth comes the risk of inflation.

The 10-year yield competes with equities for investor capital. Higher yields can pressure stock valuations by increasing the discount rate for future earnings, while lower yields can boost equity appeal.

In essence, the 10-year Treasury yield provides a handy gauge of the economy’s pulse, shaping decisions across the financial landscape.

As the following chart shows, the 10-year yield has sharply risen over the past several months, although in recent days it eased a bit amid the latest inflation data, which showed the “Goldilocks” conditions Wall Street prefers:

The yield hovers at 4.60% (as of market close Friday, January 17), above its 20-, 50-, and 200-day moving averages, denoting momentum on the upside. The yield hit a low of nearly 3.60% in mid-September 2024.

Inflation has indeed fallen but it remains stubbornly sticky, which is likely to prompt caution from the Fed and to keep rates from markedly dropping.

Decreasing foreign demand for U.S. Treasurys also is elevating yields. China’s central bank this month suspended Treasury bond purchases, in a move designed to defend the yuan, which has been sliding since the surprise election of Trump as U.S. president.

What’s more, Trump’s promises—to slash corporate taxes and escalate a trade war—are raising alarms over ballooning deficits and potential inflation. The bond vigilantes, originally labeled as such by economist Ed Yardeni, have historically stepped in to punish profligate fiscal policies by driving up borrowing costs. And while the bond market doesn’t speak with words, its actions are deafening.

Historical Parallels: Clinton’s Lesson in Fiscal Discipline

I’m old enough to recall a similar episode during Bill Clinton’s presidency. Back in the early 1990s, Clinton’s progressive agenda hit a wall, courtesy of the bond market. Skyrocketing yields forced him to shelve some of his ambitious spending plans and pivot toward deficit reduction, a move that won over Wall Street but frustrated many within his party.

In April 1993, Clinton famously lamented:

“Where are all the Democrats? I hope you’re all aware we’re all Eisenhower Republicans…We’re Eisenhower Republicans here. Here we are, and we’re standing for lower deficits and free trade and the bond market. Isn’t that great?”

Fast forward to today, and the parallels are striking. The bond market is already signaling its unease, serving as an early warning system for policymakers and investors alike. And while Trump’s populist rhetoric might play well at rallies, the bond market is less forgiving, especially when faced with the prospect of fiscal recklessness.

The Bond-Stock Relationship: A Tale of Opposites

Rising bond yields and stock prices often move in opposite directions, and the reasoning is simple. When bond yields rise, borrowing costs increase for corporations, squeezing profit margins.

Higher yields also offer a more attractive, relatively risk-free alternative to equities, pulling money out of stocks. Higher yields also make lofty equity valuations harder to justify. Investors are essentially recalibrating their risk appetites, shifting from growth to safety.

This dynamic is particularly relevant now. The recent spike in yields isn’t just a response to immediate inflation concerns; it’s a preemptive strike against the potential for long-term economic instability. Stock investors, buoyed by recent market gains, may find themselves blindsided if they continue to dismiss these warning signs.

Complacency in Corporate America and Wall Street

Perhaps the most alarming aspect of the current climate is the pervasive complacency among corporate executives and Wall Street analysts. The prospect of a second Trump term, with its potential for both domestic and geopolitical turbulence, has elicited little more than a collective shrug. It seems that the prospect of more tax cuts trumps (pun intended) all other concerns.

But ignoring the bond market’s signals is a dangerous game. Corporate America’s reliance on cheap debt to fund stock buybacks and acquisitions could backfire spectacularly if borrowing costs rise. And Wall Street’s penchant for short-term gains over long-term stability may soon face a rude awakening.

How Investors Should Navigate the Chaos

So, what’s an investor to do? Here are some strategies to consider:

1. Embrace Quality: Focus on companies with strong balance sheets and low debt levels. Rising yields will hit overleveraged firms the hardest.

2. Diversify with Inflation Hedges: Consider adding inflation-protected securities (like TIPS) and commodities to your portfolio. These can serve as buffers against potential inflationary pressures.

3. Rotate into Defensive Sectors: Utilities, healthcare, and consumer staples tend to perform well during periods of economic uncertainty and rising interest rates.

4. Short Overpriced Equities: Overvalued growth stocks, particularly those with sky-high price-to-earnings ratios, could see sharp corrections as yields climb.

As the bond vigilantes saddle up, remember that the market is a merciless arbiter of reality. Trump’s policies may promise a return to American greatness, but the bond market isn’t buying it…literally.

It’s up to investors to listen to these subtle, yet forceful, signals. And while it’s tempting to dismiss rising yields as mere noise, doing so might leave you on the wrong side of history—and your portfolio on the wrong side of profitability.

After all, when the bond vigilantes ride into town, it’s not just a warning. It’s a call to circle the wagons.

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John Persinos is the editorial director of Investing Daily.

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