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.
While large tech companies ("hyperscalers") are issuing significant debt, their volume is trivial compared to the government's. The US Treasury's massive issuance is the primary factor forcing investors to demand higher yields across the board, effectively crowding out corporate borrowers rather than the other way around.
Shrinking the Fed's assets requires a corresponding reduction in liabilities. The largest reducible liability, bank reserves, is hard to shrink because post-2008 regulations and interest payments make reserves a highly useful "Swiss army knife" asset for banks. They are reluctant to give them up, creating a "ratchet effect" that keeps the Fed's balance sheet large.
Unlike their intended purpose of improving liquidity for illiquid bonds, the Treasury's recent buybacks were a strategic signal. With market functioning metrics appearing normal, the move was an attempt to communicate the Treasury's belief that long-term yields were fundamentally mispriced, although the market's quick reversal showed the limited power of this signal.
The Federal Reserve is determined to maintain its independence from the Treasury's fiscal needs. It will not entertain discussions about managing bond yields to lower government borrowing costs, a stance rooted in the acrimonious "Fed-Treasury Accord" of the 1950s, a conflict the Fed is unwilling to repeat.
Rather than just shrinking its balance sheet, a key Fed reform could be altering its composition. It's predicted the Fed will swap long-term Treasury holdings for short-term T-bills. This would better align the interest it earns on assets with the interest it pays on bank reserves, reducing the volatility of the Fed's own income statement.
The Treasury's buyback program was not initially designed for yield management. Its primary function was to clean up small, illiquid, "off-the-run" pieces of old debt that clogged dealer balance sheets. By swapping these "odd lots" for new Treasuries, the program aimed to improve market functioning and save taxpayer money.
Even the powerful U.S. Treasury cannot dictate bond yields if the market decides they should be elsewhere. The 1992 attack on the British pound serves as a historical example. The sheer scale and collective judgment of global bond investors will ultimately overwhelm a single government entity's attempts to control prices.