It is less than a week before American voters decide who will be the next president. The high volatility of U.S. government bonds before this highly anticipated election is undoubtedly causing many industry veterans to feel anxious.

Senior macro strategist Benjamin Picton from ABN AMRO Bank warned in a report published this Wednesday that a debt crisis may have already shown early signs.

Picton pointed out, "I deliberately choose to say this: America is about to decide on its next president, no longer the next 'leader of the free world,' because one of the options on the table is to take a more isolationist approach in trade and foreign policy, the United States may refuse to play its leadership role, urging those unwilling allies to take on more global security responsibility."

Picton stated that this could mean the end of the 'U.S. world policeman' neo-conservative phase, and it is now clear that the potential impact of the U.S. bond market and the U.S. dollar index on Trump's re-election is becoming increasingly sensitive.

As shown in the chart below, since the mid-September 50-basis-point rate cut by the Fed, the 10-year U.S. Treasury yield has actually risen by more than 55 basis points. Americans who have been waiting for a Fed rate cut before buying a house are facing '7-handle' mortgage rates again – because U.S. mortgage pricing tends to be more aligned with changes in the long end of the yield curve.

Picton said that the current shape of the U.S. Treasury yield curve can explain a lot. Although OIS interest rate futures pricing has weakened the prospect of further Fed rate cuts this year, the 2s10s (2-year vs. 10-year) U.S. Treasury yield spread continues to rise. The 2s10s yield curve was still inverted in early September, but the spread is now at 15.5 basis points. Interestingly, since the Fed rate cut, the 2s30s spread has not steepened at all.

What does this indicate? In short, the market expects a reduction in the frequency of Fed rate cuts in the short term, and the inflation rate over the next ten years may be higher than the level people have been accustomed to recently. So why is this happening? As the probability of Trump winning the election increases, the market is repricing assets to reflect the world situation after the implementation of Trump's policy agenda – Trump himself is a big-spending person, he supports comprehensive tax cuts and universal tariff imposition, which most economists will tell you will lead to inflation.

But Trump's victory is not the only reason for the bear market in the bond market. Harris himself is not a fiscal hawk, and as countries increase their spending on medical, retirement, defense, and interest payments, people are once again concerned about the global debt burden and the possibility of further increasing debt burdens.

Bond holders are becoming scapegoats.

Picton pointed out that recent price trends seem to be a victory for the 'rational expectations' theory, but other elements of economic theory are also shining.

Rational expectations is an economic hypothesis that refers to people's rational expectations of an economic phenomenon. They will maximize the use of available information to act without making systematic errors.

A low but stable inflation target is a good thing, based on the concept of 'nominal rigidity'. Fundamentally, this view holds that some prices in the economy are 'sticky', preventing the market from achieving self-balancing as classical economists often suggest.

An example of this might be the decline in US home sales as sellers refuse to adjust price expectations to reflect the current economic conditions. Another example could be that due to the defeat of the European auto industry in competition, Volkswagen in Germany plans to cut car workers' wages by 10% (certainly will face opposition from the union).

In both cases, market quotes (for housing and labor) remained sticky, without adjusting based on harsh economic realities. Bid-ask spreads widened, trading activity dried up. So, how do the leading neo-Keynesian economists from central banks and national treasuries address this issue? They do so by creating enough inflation to raise buying prices to meet those sticky quotes, thereby providing lubrication for the wheels of the economic machine to run smoothly.

Later on Wednesday, UK Chancellor Rieves unveiled her first budget, where people may be able to see some traces of this approach. Rieves announced increases in taxes and borrowing for investment - from an additional borrowing of £142 billion to the largest tax hike in at least 30 years, the scale of the budget is staggering.

Picton pointed out that the current proportion of UK debt to GDP has exceeded 90% (higher than the USA), which is the critical point estimated by economists Carmen Reinhart and Kenneth Rogoff where the Keynesian multiplier would be less than 1 (although this theory has been highly controversial over the past decade). In simple terms, when the multiplier is less than 1, it means that for every extra dollar the government spends, GDP growth is less than one dollar. Therefore, due to the debt growing faster than GDP, borrowing and stimulus measures may backfire.

How to break free from this economic downturn cycle?

Picton believes there are two options: choose default or fiscal austerity policies. However, fiscal austerity can actually be ruled out, as no government dares to seriously propose austerity after attempts by George Osborne (former UK Chancellor of the Exchequer) and Shoibler (deceased former German Finance Minister) severely undermined the social contract. In terms of default, countries without the power to issue their own currency can only default outright (think Greece), while governments of sovereign currency issuers can 'default' by stealthily devaluing their national currency.

Picton states that this is the scenario of financial repression - bondholders will be the scapegoats, providing funds for fiscal profligacy by holding securities with actual negative yields. In this situation, smart money will exit the bond market and hold tangible assets that can hedge inflation.

The S&P 500 index has risen by over 22% year to date, while long-term US bond yields are also increasing. Is this what the market envisions for the future as the early signs of a debt crisis emerge?

Editor/new