Politicians will continue running large deficits as long as the bond market tolerates it by keeping interest rates low. The ultimate correcting mechanism for government spending isn't political discipline, but the bond market's impersonal decision to raise rates, forcing fiscal responsibility.

A powerful, non-obvious driver for investment-grade debt is overfunded pension plans. They are selling equities after a strong run and reallocating to fixed income to lock in high yields and de-risk their portfolios, creating a massive wave of demand that absorbs record supply.

The surge in bond yields is less about inflation fears and more about basic supply and demand. Discretionary investors like hedge funds require a higher yield to absorb the ever-increasing volume of government debt, as traditional buyers like foreign central banks are no longer increasing their holdings.

In a world where the government is the largest debtor, raising interest rates acts as a fiscal transfer, increasing income for the private sector (bondholders). When this is financed through monetized bill issuance, higher rates can paradoxically become an economic stimulus, not a contractionary force.

Pension funds, now overfunded at 112%, are de-risking by shifting from equities to long-duration credit. This, combined with retiring boomers seeking income via annuities, has created a powerful, persistent demand wave for corporate bonds, absorbing record supply.

Rising long-term bond yields act as a self-correcting mechanism for the economy. As yields climb, they tighten financial conditions and slow growth, which in turn reduces inflation expectations and eventually causes yields to fall. This "pendulum effect" is a key market dynamic.

When a central bank signals a series of rate hikes, investors delay buying bonds, waiting for rates to peak to lock in the highest possible yield. This counterintuitive behavior means an initial rate hike can fail to attract capital and support the currency, as it creates an expectation of better returns in the future.

Unlike global peers where rising yields are tied to rate hike expectations, the US long-end sell-off is driven by an expanding 'term premium'. This signals investors are demanding more compensation for risks related to US fiscal sustainability, not just monetary policy.

The market's reaction to a rate hike depends on the driver of pre-hike yield increases. If rising term premium (the market demanding policy credibility) is the cause, a hike can actually lead to lower long-term yields. This is because the Fed is satisfying the market's demand for tightening.