Despite concerns over war-induced inflation, signs indicate that other factors are exerting equally significant pressure on long-term borrowing costs. In the United States, the so-called real yield, which is the Treasury yield adjusted for inflation, has recently become the primary driver behind the rise in U.S. bond yields. This suggests bond investors are worried about more than just inflationary pressures stemming from rising oil prices. Other key culprits include: the apparent worsening of an already substantial public debt burden; the adverse effects of the AI investment boom; and the increased likelihood that central banks like the Federal Reserve will raise rather than lower interest rates. Analyses, including one from an institution, along with strategists from ING Bank NV, Goldman Sachs, and Barclays, unanimously agree: even if inflation, which has risen alongside climbing oil prices, cools down, the recent uptrend in long-term yields is unlikely to fully reverse in the near term. In other words, even if the Middle East conflict concludes, market borrowing costs are likely to remain near multi-year highs, continuing to pressure government finances and the broader economy. Jonathan Hill, Head of U.S. Inflation Strategy at Barclays, stated that attributing the global sell-off in long-term bonds entirely to inflation concerns does not align with how markets are pricing medium-to-long-term inflation risks. The real drivers pushing up real interest rates are likely the interplay of increased debt, a higher neutral rate, and AI. The neutral rate refers to the interest rate level that neither stimulates nor slows down the economy. While soaring oil prices may dominate headlines, the increase in breakeven inflation rates—a measure of inflation expectations in the bond market—has been far less than the overall rise in U.S. and U.K. interest rates. Hill pointed out that even with ongoing hostilities, the U.S. 10-year Treasury breakeven rate remains 50 basis points lower than during the Fed's aggressive rate hikes in the first half of 2022. The so-called 5-year, 5-year forward breakeven rate, a market gauge of medium-term inflation expectations, stands at 2.2%, roughly the same level as in December. Economists Claudio Irigoyen and Antonio Gabriel from Bank of America assess the factors influencing the bond market by observing changes in the yield curve. They noted that, with the potential for the Fed to hike rates again and the U.S. debt interest burden continuing to climb, the fiscal deficit could worsen further. Consequently, Fed policy, which traditionally impacts short-term rates more directly, is now exerting a greater influence on long-term bond yields as well.
Subtracting inflation-adjusted yields from nominal yields yields the "real yield," which some market participants consider a more accurate measure of true borrowing costs. An institutional analysis shows that the recent rise in U.S. Treasury yields has been primarily driven by climbing real yields. In contrast, yield movements in Japan and Germany remain largely influenced by inflation factors. Padhraic Garvey, Regional Head of Research for the Americas at ING, stated that with real yields staying high, this implies long-term interest rates could remain "stuck at elevated levels" even if the Strait of Hormuz—a critical global energy chokepoint closed due to the conflict—eventually reopens. He believes the entire move that pushed the U.S. 10-year Treasury yield above 4.5% was driven by rising real yields. The U.S. 10-year yield approached 4.70% last Tuesday before retreating to 4.56% on Friday. "Reopening the Strait would dampen inflation expectations, but real yields could still stay high. If that's the case, Treasury yields won't fall back as sharply as many currently expect," Garvey said. Mark Malek, Chief Investment Officer at Muriel Siebert & Co., wrote in a client note that the bond market is not reacting to a single news event; it is repricing a structural problem that cannot be solved by press releases or diplomatic pauses. U.S. senior officials said on Sunday that the U.S. and Iran are nearing a deal that would reopen the Strait of Hormuz, but U.S. President Donald Trump stated he would not "rush" into an agreement. In early Asian trading on Monday, crude oil prices fell, and U.S. Treasury futures prices edged higher.
Reasons U.S. yields may stay elevated include: Trump's push for tax cuts, which would further widen an already massive fiscal deficit and debt burden, forcing increased U.S. bond issuance. Additionally, Trump's ongoing trade war could further disrupt supply chains. JPMorgan Chase CEO Jamie Dimon said in an interview last week that U.S. rates could rise significantly further, citing concerns over government borrowing and demand for U.S. Treasuries. Phillip Lee, Head of Real Money Rates Sales at Goldman Sachs, noted that persistent fiscal deficits, increased Treasury issuance, and market concerns about debt sustainability increasingly explain why investors demand higher compensation to hold long-term bonds. "I think rates are going to go higher," he said during a Goldman Sachs podcast. While markets widely bet on Fed rate cuts at the start of the year, traders now believe the Fed may have to hike rates this year, even with Kevin Warsh as its chair. Although AI might suppress inflation in the long run by boosting productivity, bond traders worry that the AI boom is adding to inflationary pressures in the short term, as tech companies massively procure semiconductors, build large data centers, and issue substantial debt for financing. Furthermore, the economic growth spurred by the AI boom may make investors favor stocks more, forcing the bond market to offer higher yields to attract capital allocation. Barclays' Hill suggested the neutral rate may have already risen, which also explains why a U.S. 10-year Treasury yield of 5% might no longer be seen as "cheap" as it once was. Data shows that since the outbreak of the Iran war, the rise in Japanese and German 10-year government bond yields has been largely driven by increases in breakeven inflation rates. Europe faces higher gasoline prices, and inflationary pressures in Japan had begun rising even before the war started. The analysis notes that with the Bank of Japan reluctant to raise rates, investors are forced to demand more compensation for inflation risk. U.K. Prime Minister Keir Starmer faces increasingly severe challenges to his position, which could lead to looser fiscal policy and increased bond issuance, just four years after the market experienced a sharp sell-off during former Prime Minister Liz Truss's brief tenure. "You certainly want to take a long-term view on gilts, but with rising political uncertainty, it almost forces you into tactical trading," said John Sidawi, Senior Portfolio Manager at Federated Hermes, in an interview.
Comments