Trumped-Up Delusions and the Madness of Crowds
The notion that increased government borrowing always drives up Treasury yields is deeply ingrained in financial markets, often treated as an indisputable truth. Yet, as Charles Mackay cautioned in his 1841 classic, “Extraordinary Popular Delusions and the Madness of Crowds”, markets have a peculiar tendency to cling to assumptions that crumble under scrutiny. Could this seemingly self-evident relationship between debt and yields be another “popular delusion”?
Conventional wisdom suggests that higher government debt issuance floods the market with bonds, forcing yields higher. But this view is overly simplistic, especially when the Federal Reserve is actively managing monetary policy. Large-scale U.S. Treasury issuance does increase the supply of bonds, but it also drains liquidity from the financial system. When investors purchase these bonds, they do so with cash, effectively reducing the amount of money circulating for other investments. This “cash drain” acts much like a tightening of financial conditions, making it more costly for businesses and individuals to borrow.
This liquidity reduction can lead to "crowding out," but not in the traditional sense. Rather than directly competing with the private sector for loanable funds, government borrowing reduces overall liquidity. This can push investors away from riskier assets and toward the relative safety of government bonds, stabilising or even lowering yields rather than pushing them up.
The Fed’s actions add another layer to this dynamic. When the central bank eases policy, it typically lowers short-term interest rates by buying bonds on the open market. These actions inject liquidity back into the system, offsetting the drain caused by Treasury issuance. This creates a nuanced effect on supply: while Treasury issuance drains liquidity, Fed purchases restore some or all of it, creating conditions that can contribute to a flatter yield curve rather than the anticipated steepening.
These dynamics challenge the belief that “more debt equals higher yields.” In fact, empirical data reveals that budget deficits have minimal predictive impact on Treasury yields. Instead, Treasury issuance and Fed easing together are more likely to contribute to curve flattening than to any significant yield increase. This is evident in the sharply flattening yield curve observed recently, as investors position themselves for the reality that safe-haven demand, liquidity flows, and central bank interventions are often stronger influences on yield dynamics than raw debt levels.
For a clearer view of how the yield curve is truly shaped, investors would do well to consider the broader forces at play—liquidity, central bank policy, and demand for safety—rather than blindly following the crowd. While challenging conventional wisdom can be daunting, making independent, well-informed decisions is often far more effective than succumbing to the “madness of crowds.”
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