Band-aids, bazookas, and boomerangs: Equity investing in a volatile US rate regime

Key points

• The forces driving long-term yields higher appear structural, and limited US Treasury interventions are unlikely to change the broader regime.
• Persistent fiscal deficits, heavy borrowing needs, shifting global capital flows, and leveraged Treasury positioning could keep rates volatile.
• For equity investors, this less stable environment argues for greater valuation discipline and could drive more frequent changes in market leadership.

Policymakers have a variety of tools for easing upward pressure on US bond yields, but those tools differ markedly in scale, speed, and staying power. Policy band-aids, including US Treasury buybacks and changes in issuance policy, can provide relief, but their effects are likely to be limited unless the measures are sufficiently large and sustained. A policy bazooka — such as quantitative easing, yield-curve control, or another material expansion of the Federal Reserve’s balance sheet — can command the market’s attention immediately and absorb a significant amount of longer-term debt. And policy signaling without commensurate action risks a boomerang effect: yields fall initially, only to retrace the move once investors reassess the underlying fundamentals.

As I discuss in this article, these distinctions matter for investors because the forces pushing long-term yields higher appear structural rather than transitory. My working assumption remains that the US is in a secular bond bear market, shaped by persistent fiscal deficits, increased Treasury issuance, greater competition for capital, energy and inflation risks, potentially less reliable foreign demand, and a more leveraged Treasury-market structure. Against that backdrop, the key question is not whether policymakers can temporarily push yields lower, but whether they will eventually take sufficient action to alter the longer-term regime.

For equity investors, this environment argues for greater valuation discipline. A structurally higher and more volatile discount rate should limit the scope for multiple expansion and produce more frequent rotations beneath the surface of the equity market. The direction of earnings still matters enormously, but I think investors should expect the valuations assigned to those earnings to be less stable than they were during the secular bond bull market.

Treasury policy: Twist-like but for now too small to change the regime

The recent Treasury action is perhaps best viewed as an attempt to influence yields through the composition of issuance rather than through monetary stimulus. In that sense, it resembles Operation Twist, last used by the Federal Reserve in 2011 – 2012 to put downward pressure on long-term interest rates by selling shorter-term Treasuries and buying longer-term Treasuries.

The problem this time around is one of scale. The initial action announced by the Treasury in August amounted to less than 5% of long-end issuance, which helps explain why the decline in yields was short-lived. Treasury Secretary Bessent’s comments suggest further adjustments may be possible, and additional upsizing could provide temporary relief. But changing the composition of supply at the margin is different from removing duration from the market altogether. The latter is what has historically produced more durable declines in long-term rates.

Looking ahead, investors should watch for measures that clarify the line between Treasury and Fed policy. One possibility would be a deal where the Fed's mortgage holdings move from the Treasury to the Fed, effectively removing the Fed from making credit allocation decisions and letting the Treasury decide if it would like to bring an end to quantitative tightening in mortgages in an effort to tighten mortgage-Treasury spreads. Such initiatives would require extensive policy work and coordination, making them more plausible in 2027.

The Fed has not capitulated yet

I continue to believe that the core of the Federal Open Market Committee remains focused on the economic data, particularly inflation and employment, rather than on concerns about Treasury financing or fiscal sustainability. The recent Treasury buyback actions and yen intervention should therefore be viewed as the Treasury acting largely on its own rather than evidence of a new coordinated Fed/Treasury regime.

Fiscal dominance may ultimately force a different relationship between monetary and fiscal policy, particularly during the next meaningful economic downturn. But we are not there yet.

In the meantime, regulatory changes that reduce banks' demand for reserves could give the Fed greater flexibility to reduce the size of its balance sheet and make it feasible to move to a more active short-term interest-rate policy — a direction that was articulated by Fed Chair Warsh.

Fiscal concerns remain at the center of the rates debate

The absence of a coordinated Fed/Treasury response is contributing to higher rate volatility as concerns periodically resurface about the government’s ability to sustain its spending policies and the risk that large deficits will put pressure on inflation.

The unusual scale of US fiscal deficits during an economic expansion is already well documented, so I won’t delve into it here. The important point is that a credible improvement in the fiscal trajectory would probably do more to assuage the bond market than repeated interventions in Treasury-market plumbing.

The surge in AI-related corporate bond issuance has added another large borrower seeking duration at the long end of the curve, increasing competition for investor capital at a time when Treasury financing needs are already substantial. Perhaps the bond market is simply reminding investors of something they had forgotten during the era of zero rates and quantitative easing: capital can become scarce enough to have a price again.

Japan: What if a longstanding source of capital reverses?

The latest concern over an unwind of the yen carry trade highlights another vulnerability. For years, Japan has been an important overseas source of demand for US financial assets. Japanese investors own more than $1 trillion of US Treasuries and have also provided substantial capital to US corporate credit and equities. If higher Japanese yields and a stronger yen make domestic assets increasingly attractive, some of that capital could migrate home.

This reinforces a point I have made previously: US asset prices are unusually dependent on continued global capital inflows. A wave of capital repatriation therefore does not have to be enormous to matter at the margin, particularly when Treasury financing requirements are already large.

Energy adds fuel to higher yields, but inflation can change the calculus

Energy has been a prominent part of the story this year. Higher energy prices can simultaneously raise headline inflation, alter expectations for Fed policy, and increase the inflation risk premium embedded in longer-dated bonds if investors begin to question the Fed's credibility.

Until now, the Iran war has contributed to upward pressure on yields by pushing energy prices higher and prompting markets to reassess the likely path of Fed policy. Any break in the clouds here would be positive for the yield backdrop, as the Fed has indicated a willingness to be patient should the data cooperate.

I am encouraged by recent results from large retailers that suggest price pass-throughs to consumers remain on the lower end, exactly what the Fed needs to see. Coupled with softer wage-growth signals, there are signs that demand-driven inflation is easing, even as supply-driven pressures from tariffs, compute shortages, and energy remain elevated.

With oil prices still a concern and unemployment remaining low, the Fed is likely to stay vigilant. Should an Iran war deal be reached, the market would price in a more benign outlook, easing pressure on equity multiples and on the consumer sector, which has been hit hard by inflationary pressures.

The basis trade makes the Treasury market more fragile

One structural change receiving insufficient attention is hedge funds’ growing use of the Treasury basis trade, a strategy that relies heavily on leverage and short-term financing. Hedge funds have roughly doubled their Treasury footprint since 2023.¹ If funding conditions tighten or volatility forces deleveraging, Treasury selling can become self-reinforcing: bond prices fall, yields rise, margin requirements increase, and leveraged investors are forced to reduce positions further.

We saw elements of this dynamic in March 2020, when hedge funds reportedly sold roughly $180 billion of Treasuries,¹ and again during the April 2025 tariff shock as stress appeared in swap spreads.

The Fed's balance sheet can eventually provide the potential policy bazooka if Treasury-market functioning becomes sufficiently impaired. But the important word is “eventually.” Given the change in leadership at the Fed, investors should not assume intervention at the first sign of market stress. This is another reason to expect the bond market to remain a source of volatility rather than the quiet part of a diversified portfolio.

What does all this mean for equities?

I would offer five key takeaways for equity investors:

1. The impact depends on what’s driving higher yields: growth, inflation, or term premia expectations — Higher yields do not automatically mean lower equity prices. Higher yields driven by stronger growth can generally be absorbed by equities the easiest, as growth usually translates into healthy profits growth, as we saw during the first half of this year.

As for higher yields driven by rising inflation, it depends on how high inflation goes. Inflation of 4% or higher is typically more challenging for equities, as tighter Fed policy often follows and companies find it harder to pass through rising costs fully. Inflation in the 2% – 3% range can be good for revenue while reducing the distinction between growth and value leadership.

Finally, rising term premia often reflect concerns about fiscal deficits and competition for capital, and with elevated P/E multiples, bond yields above 4.5% are putting a cap on equity valuations.

Year to date, the increase in yields has been driven more by rising real rates than by higher inflation expectations. As a result, market P/Es have contracted, with earnings growth doing the heavy lifting for equity returns.

2. Valuation discipline is more important — When the risk-free rate moves high enough to compete with equity earnings yields, high-P/E stocks have less room for disappointment, even when their fundamental growth stories remain intact.

3. More frequent rotations should be expected — Markets will repeatedly move between growth, inflation, fiscal-dominance, and liquidity narratives. Those shifts can produce significant changes in sector and style leadership even when the broad index goes nowhere.

4. Rate volatility bears watching — The combination of leveraged Treasury positioning and large financing requirements noted above increases the risk of nonlinear moves in yields. That argues for treating rate volatility itself, not simply the level of the 10-year yield, as an important equity-market variable.

5. Disinflation could provide yield relief — Softer inflation, whether it’s driven by lower energy prices, easing tariff effects, or simply the passage of time, would limit the need for Fed rate hikes and create a virtuous cycle of reinforcing growth expectations and easing concerns about US debt sustainability.

¹Source: Decomposing Hedge Funds’ US Treasury Exposures, Federal Reserve, 22 June 2026.