Despite widespread concerns over inflation triggered by Middle Eastern conflicts, evidence suggests that other factors are exerting equally significant pressure on long-term borrowing costs.
In the United States, the so-called real yield—the return on government bonds after adjusting for inflation—has recently emerged as a primary driver behind the rise in U.S. Treasury yields. This indicates that bond investors are worried about more than just inflationary pressures stemming from rising oil prices.
Other key contributors include: the apparent worsening of already substantial public debt burdens; the adverse impacts associated with the artificial intelligence investment boom; and an increased likelihood that central banks, including the Federal Reserve, might raise interest rates rather than lower them.
Analyses, including one from Bloomberg, alongside strategists from ING Bank NV, Goldman Sachs, and Barclays Bank, concur that even if inflation—which has been fueled by climbing oil prices—subsides, the recent upward trend in long-term yields is unlikely to reverse completely in the near term.
In other words, even if the Middle Eastern conflict concludes, market borrowing costs are likely to remain near multi-year highs, continuing to exert pressure on government finances and the broader economy.
Jonathan Hill, Head of U.S. Inflation Strategy at Barclays Bank, noted that attributing the global sell-off in long-term bonds solely to inflation concerns does not align with how the market is pricing medium- to long-term inflation risks. The real drivers pushing up real interest rates are likely the interplay of increasing debt, a higher neutral interest rate, and the influence of AI.
The neutral interest rate refers to the level at which it neither stimulates nor slows down the economy.
While surging oil prices may dominate headlines, the increase in breakeven inflation rates—which gauge inflation expectations in the bond market—has been far less pronounced compared to the overall rise in interest rates in the U.S. and the U.K.
Hill pointed out that even as hostilities continue, the breakeven rate on the U.S. 10-year Treasury note remains 50 basis points lower than it was during the first half of 2022, when the Federal Reserve was aggressively raising rates. The so-called 5-year, 5-year forward breakeven rate—a market indicator measuring medium-term inflation expectations—stands at 2.2%, roughly the same level as in December.
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