U.S. debt is the ‘elephant in the room’ amid bond market rout as Fed-fueled interest costs could drive even larger deficits, analysts warn

Recent weeks have seen a major selloff in the bond market as high oil prices spike inflation, but deteriorating U.S. fiscal health is increasingly a dominant factor, according to analysts at Bank of America.

In a note on Friday, BofA announced that the so-called bond vigilantes have returned, referring to traders who protest huge deficits by selling off bonds to push yields higher. 

That’s as long-term yields hit the highest levels since the Great Financial Crisis on Tuesday due to hot inflation data, lack of a deal to reopen the Strait of Hormuz, strong consumer spending, and continued resilience in the labor market.

“In our view, unsustainable fiscal dynamics are compounding with a reflation story, turning a short-term problem into a long-end selloff,” analysts wrote.

But that’s not the whole story. Economic data indicating more inflation as well as ongoing uncertainty about the Iran war preceded the bond market rout, BofA pointed out.

Plus, high inflation and resilient growth would typically lead markets to price in rate hikes from the Federal Reserve, flattening the yield curve as short-term rates rise more than long-term rates.

However, the opposite happened as the yield curve got steeper with long-term rates leading the charge higher....