As US government spending escalates, fixed interest markets are a bellwether for equities and the global economy.

There’s been a lot of chatter about bonds flashing red, signalling a potential financial crisis and forcing US president Donald Trump to capitulate on an aggressive new round of global tariffs. But just how do these markets work and what risks do they pose for future market stability?

Bonds are debt instruments through which an investor lends money to a borrower like a government or company. In exchange for the loan, the borrower or issuer agrees to repay the principal amount at a specified maturity date and make regular interest payments, known as coupons, at a fixed rate over the bond’s lifetime.

For traders, bond yields are a key data point. A bond’s yield reflects the return based on the bond market price and the yield fluctuates with changes in bond prices and market conditions. There is an inverse correlation between bond yields and bond prices such that if the yield rises, the bond’s price falls. Bond yields are forward looking and take into account expectations around economic growth, inflation and monetary policy.

“Rising bond yields may point to the market predicting a pickup in growth which might also push inflation higher. While an increase in growth may sound positive, higher inflation would likely lead to an increase in interest rates, which could squeeze corporate profits, particularly for heavily indebted companies,” says Income Asset Management executive director, capital markets, Darryl Bruce.

Falling bonds yields often reflect uncertainty about the economic outlook and fears of weaker economic growth.

“Yields get pushed down as demand for bonds from investors increases, as they look for a safe haven to ride out the uncertainty. Blue chip equities might also benefit in these conditions, but uncertainty is unlikely to be supportive to more speculative stocks,” says Bruce.

While lower yields are often a precursor to an economic slowdown, an inverted yield curve, where long-term yields are lower than short-term yields, is frequently viewed as an indicator of a coming recession.

Widening Credit Spreads Signal Growing Investor Caution 

Relatedly, widening credit spreads are a sign of risk aversion. Widening credit spreads happen when the yield gap between riskier corporate bonds and safer government bonds increases. This signals heightened investor concern about corporate defaults due to economic uncertainty, deteriorating financial conditions or rising borrowing costs for issuers.

UBS Global Wealth Management Australia investment consultant, Mark Trevarthen, explains credit spreads represent the risk premium attached to a corporate bond above the risk-free rate.

“If the five-year government bond yield is 3.50 per cent and a corporate five-year bond yields 4.00 per cent, we can say the credit spread for a corporate, five-year bond is 50 basis points. These 50 basis points represent the risk premium and reflect the corporate’s cost of funding via the credit market,” says Trevarthen.

If this spread were to widen it would materially impact the corporate’s cost of funding and would feed through to its margins, which would ultimately have a negative impact on its equity.

Turning to what’s happening at the moment, bond prices could fall as yields increase if the US is forced to issue more US government bonds, known as treasuries, than the market expects.

“We're in uncharted territory, or at least in territory we haven't charted for some time,” says GSFM Funds Management market analyst, Stephen Miller.

“Those of us who have been around for a while are scratching our heads and looking for precedents and wondering what's going on. Markets are still getting used to this new era and their response needs to be taken with a grain of salt.”

One Big Beautiful Bill Reaction

Broadly, bond markets are worried about US president Donald Trump’s agenda and an inflection point around inflation. Markets are especially concerned about the US’s budget reconciliation bill, which would add to the budget deficit and, according to some commentators could increase US government debt by US$4 trillion. These funds would need to come from issuing US treasuries.

“The bond markets are genuinely concerned about the US budget deficit and the bill will only add to that. What markets are saying is the US is not that far from full capacity, yet the budget deficit is well north of six per cent of GDP and the Trump administration is going to add to that,” says Miller.

“Politically, a lot of the blame for this can be sheeted home to the previous US administration as much as it can be to the current administration. But that's by the by. The US is going to have to issue bonds to fund that budget deficit,” he says.

There’s every possibility the US deficit could widen should its government need to raise more money for whatever reason, such as needing to fund more defence spending, putting even more pressure on bond markets.

A challenge is traditional buyers of US treasuries such as China are likely to be re-thinking their US treasuries strategy. Japanese retail investors, who have also been traditional buyers of US Treasuries, are also thought to be turning their attentions to alternatives like Japanese bonds, because their yields are rising after years of flat returns.

Bond traders don’t have a crystal ball and markets overreact. But keep an eye on bonds and see them as a data point when forming views about the way ahead for shares and economic growth.

Want to Build Confidence in Bond Investing?

As markets grapple with widening credit spreads, shifting inflation expectations, and rising government debt levels, understanding the fundamentals of bonds has never been more important. Whether you're navigating corporate credit risks or trying to interpret movements in treasury yields, a solid foundation in bond markets is key.

Access FINSIA Microlearning: A Guide to Bonds and strengthen your understanding of one of the most important asset classes in global markets.