Bond yields have been eye-watering in recent days, which might be expected to bring slower growth across a range of industries, including real estate and construction.
But at this stage the rising yields do not jeopardize economic growth, in part because the cause of the recent surge has shifted.
For most of this year, 10-year Treasury yields rose due to inflation fears and a growing national debt that crossed the $40 trillion threshold last month. But Wednesday's surge came, in part, from higher expectations of economic growth and warnings from Federal Reserve officials that more rate increases are likely on tap this year to tame inflation.
"The current level of bond yields does not pose a threat to economic growth," Sonal Desai, global chief investment officer for Franklin Templeton Fixed Income tells Barron's. Instead, the upward trend is more of a "normalization," she says. Yields are reverting to their long-term average.
"They are consistent with the economic outlook, not abnormally high. The outlier was the period stretching from the global financial crisis through the Covid-19 pandemic, when yields were kept at abnormally low levels," Desai adds.
As one sign of the strength of the economy, the September S&P Global U.S. manufacturing purchasing managers survey, which measures business activity and sector growth, climbed to its highest reading in more than five years.
Although manufacturing production and order have been expanding most of the year, the latest data signaled that hopes of a booming economy were coming to fruition.
That, however, creates a complicated path for the Federal Reserve. The central bank raised the fed funds range to 3.75% to 4% last week to return inflation to the Fed's 2% target in a speedier fashion. If the economic growth takes off, it could mean policymakers will need to implement more rate increases than anticipated.
"When yields rise because the economy is strong, the Fed has a harder problem than when they rise on fear alone," says Mark Malek, chief investment officer at Siebert Financial. "A booming economy doesn't need rescuing, and it isn't going to cool off by itself."
Currently, Fed officials have penciled in just one more rate increase for 2026 and none in 2027, according to the latest summary of economic projections released last week. But the futures market is now predicting three rate hikes over the next 12 months and the 2-year U.S. Treasury note yield is signaling four rate hikes over the next 12 to 24 months.
Yet the higher yields are not just from signs of stronger, economic growth. There are underlying structural forces at play that have long pushed up the longer end of the curve, including larger fiscal deficits, stronger private capital demand driven by artificial intelligence, greater inflation volatility, and questions around domestic and international policy.
"These forces are keeping rates structurally higher, so when cyclical shocks emerge, yields are rising from an already elevated base," says Gregory Daco, chief economist at EY Parthenon.
Higher yields are a reminder that we have a "parlous" fiscal situation that needs to be addressed, Desai says.
"The U.S. continues to run an outsized budget deficit, and the fiscal outlook is weak in other advanced economies as well, with no major political parties willing to take corrective action," Desai says. This implies large funding needs, which compete with the demand for financing from the AI investment cycle. Large fiscal deficits would remain a source of upward pressure on yields and need to be addressed.
It's important not to forget the Fed messaging over the past week also helped boost bond yields. Philadelphia Fed President Anna Paulson on Thursday was the latest to join a growing number of policymakers, including New York Fed President John Williams, St. Louis Fed President Alberto Musalem, and Fed governor Michael Barr who believe further rate increases may be needed to ensure that inflation returns to the 2% target in a timely fashion.
"For the Fed, I think these yield levels also bring proof that financial markets are pricing in a more credible anti-inflation stance from the central bank," Desai says. During last week's FOMC press conference, Chairman Kevin Warsh "convincingly" demonstrated that he is a hawk, not a dove, Desai says. That's in contrast to the belief of many market participants that he would be soft on inflation to accommodate President Donald Trump's desire for lower rates.
"Markets have had to adjust their expectations and reprice accordingly, especially because the press conference signaled that we could easily see one or two more rate hikes," Desai says.
It's important to not extrapolate too much from one data set. While Wednesday's PMI data gives the impression of surging manufacturing and services activity, other surveys have shown more modest momentum, Daco says. Additionally, hard data continue to point to moderate growth, he added.
"Certain parts of the economy are showing strength, but that does not mean that all parts are equally firing on all cylinders," says Jeffrey Roach, chief economist at LPL Financial. Housing data, for example, continues to show a sector under pressure-and higher mortgage rates are unlikely to help.
Higher yields in the bond market, however, could help do some of the Fed's work for it by cooling demand, Malek says. With the 10-year yields hovering around 5.1% on Thursday, that will boost mortgages and corporate bonds since they're priced off longer-term Treasury yields, rather than the fed-funds rate.
"Higher yields also raise the cost of capital that companies use to value their future profits, which pressures stock valuations," Malek says. "If stocks reprice, households lose some of the wealth effect that has been supporting their spending, and consumption slows too."
That could ultimately slow growth and, eventually, inflation as a secondary effect. So the message from the bond market is not simply that the Fed needs to raise rates more, says David Miller, chief investment officer and senior portfolio manager at Catalyst Funds. Fed officials will need to be discerning in the coming months to determine if the bond market itself is applying enough restraint.
It may not be enough to keep the Fed from hiking. Roach points out that the U.S. is not as rate-sensitive as just a decade or so ago. "The Baby Boomers have plenty of cash to spend, and so higher rates will not impact them," Roach says.
At the end of the day, higher bond yields align well with the Fed's determination to bring inflation back to the 2% target in a way that does not endanger the healthy performance of the U.S. economy and the labor market, Desai says.
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