Sudden return of the Trump trade sends Treasury yields reeling

Treasury yields, which rise when bond prices fall, started surging June 28, a day after a debate between President Biden and former President Donald Trump that Wall Street viewed as delivering a major blow to Biden’s re-election chances. A poor showing from Biden could also help tip control of Congress to Republicans, creating more space for their budget priorities.

“Something obviously changed pretty quickly on Friday," said Dan Mulholland, head of rates trading and sales at Crews & Associates. Investors, he said, are assessing “how we’re going to move forward after the Thursday debate, and I think there have been some pretty big bets that have been placed."

A rule of thumb on Wall Street holds that budget deficits tend to be larger under one-party control. Many investors think that elevated deficits have already played a role in driving up Treasury yields in recent years by increasing the supply of bonds that the market must absorb and putting upward pressure on inflation—prompting the Federal Reserve to set interest rates higher than they would have done otherwise.

As a candidate this year, Trump has made broad promises about cutting taxes. He has also said he would impose sweeping tariffs, which analysts say could have an uncertain economic impact, potentially adding to inflation but also raising revenue and slowing economic growth.

Investors, though, have focused mostly on how large pieces of a 2017 tax law are scheduled to lapse after the end of next year. Many expect a Republican-controlled Congress and White House would extend all of them, reducing projected revenue by nearly $4 trillion over the next decade.

President Biden wants to only extend tax cuts for households making under $400,000, letting taxes rise for those above that threshold. Administration officials say any tax-cut extensions must be offset with higher taxes on high-income households and corporations, a goal that could prove challenging even if Democrats do well in November.

The yield on the benchmark 10-year U.S. Treasury note stabilized Tuesday, settling at 4.435% according to Tradeweb, up from 4.287% Thursday before the Biden-Trump debate.

Some analysts have questioned the assumption that the prospect of a Republican sweep should translate to higher yields. Analysts at Goldman Sachs wrote in a recent report that “the range of potential fiscal deficits under different election outcomes is fairly narrow." Further, they wrote that Trump’s plan to raise tariffs could drive yields lower by dragging on economic growth.

Investors also said that Treasurys might have already been primed for a selloff after rallying last month following encouraging inflation data. That rally pushed the yield on the 10-year note 0.5 percentage point below the two-year note—a threshold that has also triggered previous rounds of selling.

The recent selloff has led to particularly sharp gains in yields on longer-term bonds, suggesting some traders might have just been unwinding their previous positions. Such a move, however, is also what many would expect from a shift toward higher deficit forecasts.

Treasury yields broadly reflect investors’ expectations for what short-term rates set by the Fed will average over the life of a bond. But those expectations are more concrete for short-term Treasurys, making them less vulnerable than longer-term bonds to an increase in the supply of bonds or concerns about the longer-term inflation outlook.

Longer-term yields also rose faster than short-term yields after Republicans swept control of Congress and the White House in the November 2016 election. That was known at the time as “the Trump trade." But it happened again in January 2021, when Democrats’ victories in two elections in Georgia gave them control of the Senate after they had already taken the House and the presidency.

In both cases, investors’ bets on more expansive fiscal policies proved justified. Republicans passed their tax cuts in 2017, while Biden signed a hefty Covid-19 relief package less than two months after his inauguration.

Many investors still expect economic data and signals from the Fed to play the largest role in dictating Treasury yields in the coming months. On the immediate horizon, they will be focused on monthly jobs numbers set to be reported on Friday and inflation data coming out next week.

Even before last week’s debate, some analysts had started to anticipate larger deficits based on revised spending and revenue projections rather than any new political developments. The Congressional Budget Office last month said it expects the fiscal 2024 deficit to reach $1.9 trillion—up from its previous estimate of $1.5 trillion and above last year’s $1.7 trillion.

That led some analysts on Wall Street to predict that the Treasury Department might have to boost the sizes of its note and bond auctions sooner than they had previously expected.

Write to Sam Goldfarb at sam.goldfarb@wsj.com