No, Bond Vigilantes Aren’t Driving Yields, Balance Sheets Are!

The 10yr Treasury yield is creeping back toward 4.75%, sparking chatter about bond vigilantes punishing US fiscal policy. But that story doesn’t hold up to scrutiny.

What we’re seeing instead is a term premium reset and structural absorption pressure, not panic. With the US running deficits north of 6% of GDP, and Trump’s proposed 2025 tax plan potentially adding another $1.3Tril to the 10yr shortfall, the narrative seems intuitive: investors should be demanding a risk premium to hold long-duration Treasuries from a structurally indebted issuer. Lets break it down.

Source - Trading View

1. Yields Are Rising, But Not Breaking Out

Source: Cross Border Capital

The rise in 10yr UST yields toward 4.75% has been noticeable, but importantly, it has been gradual and controlled, not sharp or disorderly. This move reflects a recalibration of term premium and market structure dynamics rather than a reaction to an impending fiscal crisis. Inflation expectations remain well-anchored, with breakeven rates and 5y5y inflation swaps showing no signs of runaway expectations. While real yields are elevated, they’re signaling a structural adjustment in how investors price long term risk, not panic about the Fed’s policy trajectory or the solvency of U.S. debt. Moreover, the yield curve itself has not steepened violently, nor has it inverted in a manner typically associated with acute regime stress or credibility loss. In fact, the move higher in yields aligns with fundamental factors: continued QT, higher supply, declining foreign absorption, and constrained balance sheet space for banks and dealers. In short, this is a mechanical term premium reset, not a bond vigilante revolt.

Source - NY Fed

2. Banks Are Buying Treasuries, Not Fleeing Them

Despite headlines warning of a potential debt crisis or bond market revolt, US banks and primary dealers have done the opposite of what such narratives suggest. Since April, they’ve accumulated over $77Bil in Treasuries, with a notable skew toward long duration coupon securities. This is not merely a result of reinvesting maturing securities or passive rollovers. It reflects active net new demand, a deliberate allocation choice. The timing of this buildup coincides with recent FFIEC updates to SLR reporting requirements, which strongly suggests that regulators are laying the groundwork for a potential rule change. In this context, banks appear to be pre positioning ahead of anticipated SLR relief, which would free up capital to hold more Treasuries without increasing regulatory leverage exposure. This buying spree also reflects a strategic view on the shape of the yield curve: if the curve steepens and the term premium normalizes, especially in the absence of central bank demand, long duration assets become more attractive. Rather than fleeing US debt out of fear, banks are leaning in, allocating capital based on a forward looking read of regulatory and market structure shifts. This behavior is not consistent with a system bracing for a debt crisis; it's more in line with institutional investors positioning for a recalibrated regime in Treasury market dynamics

Source - US Treasury

3. Foreign Buyers Are Fading

A major source of quiet but powerful pressure on UST yields is the declining participation of foreign buyers, particularly China and Japan. TIC (Treasury International Capital) data shows that foreign official holdings of Treasuries have flattened out or declined over the past year, even as US issuance continues to rise. This isn’t just cyclical, it's structural. Several forces are contributing to this disengagement: ongoing FX interventions by countries like Japan, aimed at supporting their weakening currencies, have led to reserve selling rather than accumulation; central banks are also diversifying away from Treasuries as part of a broader reserve reallocation strategy; and importantly, hedging costs have become prohibitively expensive, especially for yen- and euro-based investors, making long-duration US debt less attractive on a currency adjusted basis. As these foreign bid anchors fade, the burden of absorbing new Treasury issuance falls increasingly on US institutions, particularly banks and dealers. But their ability to step in is constrained by leverage limits unless SLR relief materializes. The result is a creeping imbalance: rising supply, weakening foreign demand, and constrained domestic balance sheets, all of which contribute to rising term premia, independent of inflation or Fed policy shifts.

Source - 2025TBAC

4. QT, SOMA, and the TGA Refill Will Tighten the Screws

While the Fed has tapered the pace of QT, it is still actively allowing its Treasury holdings to roll off the balance sheet, contributing to a steady drain in system-wide liquidity. The current cap on SOMA runoff for Treasuries is $5Bil per mth, down from $25Bil but the Fed remains a net seller, not a source of demand. At the same time, the Treasury General Account (TGA) is being drawn down to fund government operations while the debt ceiling remains unresolved. Once that impasse is lifted, however, the Treasury is expected to rebuild the TGA rapidly, likely issuing $500 billion to $600 billion in short-term bills within weeks to replenish its cash buffer. This creates a powerful liquidity squeeze: as cash is pulled from money markets and bank reserves into the TGA, private balance sheets are forced to absorb the deluge of issuance. But those balance sheets, especially at banks and dealers, are already under pressure from rising duration risk and capital constraints like the Supplementary Leverage Ratio (SLR). Without regulatory relief, the combination of continued QT and a TGA-driven issuance wave risks exhausting market absorption capacity, leading to upward pressure on yields and potential dislocations in repo and funding markets. It’s not just about supply; it’s about who has the balance sheet space to handle it.

Source: FRED

5. The Real Risk: Duration Shock, Not Vigilante Revolt

The most underappreciated risk in the Treasury market today isn’t a political revolt over deficits, it’s a mechanical duration shock triggered by balance sheet saturation. As the Treasury prepares to issue more long dated bonds to fund structural deficits and rebuild the TGA, the absorption burden will fall squarely on US banks and dealers. But unless regulators ease the Supplementary Leverage Ratio (SLR) soon, those institutions will increasingly bump up against capital constraints, limiting their capacity to take down duration. In this environment, auction tail risk rises sharply: if primary dealers can't digest the supply, clearing yields will rise, and liquidity in the long end will deteriorate. Importantly, this will not be a macro-driven repricing due to inflation or Fed tightening, it will be a term premium adjustment born from funding mechanics. The upward move in long end yields, in that case, will reflect the market’s struggle to clear supply, not a loss of confidence in the government’s solvency. This is what distinguishes a duration shock from a fiscal crisis. Without SLR relief, the Treasury market may begin to exhibit symptoms of structural stress, wide bid-ask spreads, failed auctions, and rising volatility, even in the absence of a true macro inflection.

Source - RepoInsights

What we’re witnessing in the bond market isn’t a rebellion against fiscal irresponsibility or a crisis of investor confidence. It’s a plumbing problem, an issue of who has the balance sheet capacity to absorb a flood of Treasury supply in a world where the Fed is stepping back and foreign buyers are no longer reliable anchors. The rise in long end yields is being driven not by sentiment, but by the mechanical limits of how much duration banks and dealers can hold under current regulatory constraints. At the center of this is the SLR, which treats USTs the same as risky assets in capital requirements. Unless the SLR is recalibrated or temporarily relaxed, balance sheets will continue to tighten just as the Treasury ramps up issuance to refill the TGA and fund a structurally larger deficit. In this environment, the curve will likely steepen, but not for the reasons many presume. It won’t be a market revolt against inflation or unsustainable debt, it will be a term premium spike born from constrained intermediation. If regulators move swiftly to ease the SLR, banks will have the flexibility to step in as buyers of last resort, stabilizing the long end of the curve and preventing a potential duration shock. But if policymakers hesitate, the market will reprice the absorption risk not because it doubts the US will pay its bills, but because it’s unclear who will hold them.