The U.S. economy keeps powering through inflation, tariffs and higher borrowing costs, defying a run-up in Treasury yields and a Fed rate increase. That has the bond market spooked.
The usual economic brakes aren't slowing growth, hiring or an AI investment boom that looks to be unstoppable. To some, AI's potential returns seem so bright that even steep interest rates won't slow down tech companies' investments.
The growth outlook helps explain the current predicament in the bond market: The yield on the 10-year Treasury note, which plays a critical role in determining rates on mortgages and other types of debt, this week hit highs not seen in nearly 20 years, climbing again Thursday to almost 5.2%.
Bond prices have sagged over concerns about surging energy prices and elevated inflation. Treasurys are facing more competition for investors' cash from an explosion of bonds issued by companies involved in the AI build-out. Strong economic data are also pushing up yields by stirring speculation that the Fed may have to raise rates even higher than previously expected to cool a potentially overheating economy.
And any Fed struggle to restrain the economy raises the risks of a misstep that does broader damage.
Reinforcing that concern, some economists worry that borrowing costs that continue to climb may do less today to slow the economy than they have in the past, potentially requiring an even bigger Fed response. The AI boom could provide kindling, as more of the benefits could ripple out to other parts of the economy, said Eric Winograd, an economist at AllianceBernstein.
"Everything that gets put into building a data center has to be built somewhere," Winograd said. "So you get this sort of idea of a filtering through the supply chain, a filtering into other areas of the economy that would broaden the base of expansion."
Late this summer, a steady drip of positive economic news put to rest fears of a slowdown. Hiring picked back up in August, and layoffs have stayed low. Manufacturers reported that business was picking up. Powered by surging AI investment, underlying economic growth turned in a hot second-quarter reading.
On Wednesday, an often overlooked report, S&P's purchasing-managers' index, provided the strongest evidence yet the economy could be picking up steam, not merely holding firm.
The report was striking across the board: A gauge of manufacturing activity registered its biggest monthly increase since 2022. A reading of service-sector activity jumped to its highest level since 2021. New orders powered growth in both sectors.
It was just one report, but it played a major part in fueling the biggest one-day increase in the 10-year yield since President Trump's "Liberation Day" tariff rollout rattled markets in April 2025.
The S&P "report yesterday was eye-opening for me," said Stephen Douglass, chief economist at St. Louis-based NISA Investment Advisors.
Douglass said he still thinks that inflation likely can return to the Fed's 2% target without the need for much higher rates. The impact of tariffs should fade and energy prices should fall as soon as the Iran conflict is resolved, he said.
But now, he acknowledged, there is a growing risk that private-sector demand could be picking up enough to "cause an overheating," resulting in more durable inflation pressure.
Higher interest rates have already been weighing on sensitive sectors of the economy, like housing. Mortgage rates hit 7% for the first time in more than a year on Thursday, capping a rise that has smothered home sales. Commercial landlords have been feeling the squeeze as well.
But many consumers' investment accounts have been lifted by soaring stocks indexes, which have been boosted by strong corporate earnings and AI optimism. Some also keep substantial savings in money-market funds, where higher interest rates boost returns, said Ed Yardeni, head of advisory firm Yardeni Research.
"One-third of U.S. households are headed by someone aged 65 or older," Yardeni said. "These people aren't looking for mortgages, they are just enjoying the higher investment returns they've been seeing."
Higher yields don't only reflect expectations of higher growth. The U.S. government debt burden has soared. Yields have also been closely correlated in recent weeks to oil prices, reflecting worries that higher energy costs could feed into broader inflation.
Investors don't appear worried the Fed will lose its grip on inflation. The breakeven inflation rate-the bond market's indicator of the inflation that investors expect-remains modest.
Instead, investors are concerned by just how much the Fed may have to raise interest rates to keep inflation in check-a question compounded by their uncertainty about how its new chairman, Kevin Warsh, will lead the institution.
Through much of the summer, many officials at the Fed shared Douglass's optimism that inflation would fall toward the central bank's 2% target on its own. But in August inflation data, prices were still moving up too fast for comfort for the Fed, which last week raised interest rates for the first time in three years in response. Most officials indicated they expect at least one more rate increase before the end of the year.
As an economy heats up, it takes higher interest rates for a central bank merely to sustain the same level of anti-inflation pressure. In his press conference last week, Warsh said that the Fed's rate increase "removed a dose of accommodation," a phrase that to many investors indicated that Warsh believes even higher rates could be necessary for the Fed to maintain its grip.
Treasury yields closely follow expectations for how the Fed will set interest rates in the future, so as investors adjust to expectations of higher short-term rates, long-term yields rise as well. Predominant bets in interest-rate futures markets show expectations that the Fed may hike rates a full percentage point by the end of 2027.
If inflation is being fueled by a strong economy and not just an energy-supply shock, it could create a big challenge for the Fed, Winograd said.
If you're the Fed, "you're really going to have to crush everything that isn't AI, if AI refuses to slow down," he said.
Comments