Bond Yields -- How High Is High?
The Very Big Picture
The world (and the US) has moved out of a 38-year disinflationary period that started in 1982 and lasted until the COVID 19 pandemic (2020). Since 2020, it has entered a period in which we expect inflation and interest rates to remain elevated for various reasons: (i) large and rising fiscal deficits; (ii) end to cheap energy; (iii) China no longer exports deflation to the rest of the world; (iv) loose monetary policies around the world since COVID 19; and (v) geopolitical risks in a multi-polar world. For more on this topic, please refer to our paper here. These trends are not easy to reverse and we expect them to be long-lasting. Bond yields will follow higher inflation rates over time.
What The Fundamentals Are Saying
Since 1962, 10-year nominal yield in the US has averaged 5.8% (all data are from the FRED database of the St. Louis Fed). It was as high as 15.8% in 1981 and as low as 0.5% in 2020. But more important is the real yield, i.e., adjusted for inflation. Since 1982, The real 10-year yield was as high as 7.5% in the early 1980s at the peak of the inflation, and as low as negative 0.4% in 2020; over that time it averaged 2.4%.
Another way of looking at it is that nominal GDP in the US grew by 5.6% in the 1Q26 – 2.0% real growth and 3.6% GDP deflator. Historically, long-term rates have been closely correlated with the nominal GDP growth of the economy.
Based on the current 10-year US inflation break-even of 2.5%, the real 10-year Treasury yield is now around 2.0%. So the real component is close to the 2.0% GDP growth. If we take the latest CPI reading of 3.8%, however, the real yield is 0.7%. Maybe the latest CPI number is “transitory” and should not be used for this calculation? Policymakers seem to believe that (again). The market had been sitting on the fence, but the recent rise in yields indicates that its benefit of the doubt may be running out. The key question now is how the gap between latest CPI number and inflation expectations will close, and how soon. Clearly, a big factor here will be the trajectory of oil prices, i.e., development of the war in Iran. Either way, inflation is on the rise, so the market is simply marking to the data and pushing rates higher.
How high is high? There is an interplay here between the long-end and the short-end of the curve. If the Fed drags its feet again and lets the inflation genie out of the bottle for the second time in 5 years, we expect further steepening of the yield curve. Revisiting the 5% area on the 10-year is not out of the question. On the other hand, if the Fed drops the easing bias and even raises rates in July, as some market commentators now predict, we expect the curve to flatten.
The International Perspective
For many years, capital exporting countries such as Japan and some countries in Western Europe had yields much lower than those in the US. That made it attractive for local investors to buy US bonds and hedge them back to local currency. However, rates in these markets have risen substantially over the last couple of years. In Germany, 10-year rates went from negative -0.50% in 2022 to 3.15% currently; in Japan they rose from 0.0% in 2021 to 2.81% currently. Although these yields are still below those in the US, the gap has shrunk and the “buy-and hedge” math no longer works. This is likely to keep local investors in their domestic fixed-income markets for now.
China has also stopped buying large amounts of US Treasuries due to economic factors (no more large current account deficits to recycle) and geopolitical ones (diversifying its reserves into gold after the sanctions on Russia that locked up Russian Central Bank’s assets at the New York Fed). All in all, rates are rising outside of the US and that reduces on the margin demand for US Treasuries from foreign buyers. In order to mobilize domestics savings, US rates need to adjust higher.
Implications
If sustained for a relatively long time, higher yields will be negative for the federal fiscal balance as debt service costs will rise. The US Treasury has shifted a lot of its recent borrowing to the short end of the curve, so if short-term rates rise further, the process will be rather quick.
If the Fed fails to raise rates in the face of rising inflationary expectations, long-term yields will likely rise further. Further rise in yields will be a dampener on economic activity and on valuation of risk assets. However, if the Fed raises rates in the near future, we expect the bond market to take this positively. As the old adage goes, markets stop panicking when policymakers do so.
With volatility comes opportunity. Bond investors are currently offered yields that they have not seen in almost 20 years. While the long-end of the US curve looks vulnerable currently, in a scenario of global recession caused by further spike in oil prices (not the main scenario for now), bonds are likely to rally, as we saw in 2007-2009 and in 2019-2020.
Disclaimer: The information provided in this financial presentation or investment-related material is for informational purposes only and does not constitute financial, investment, or legal advice. Investing in financial markets involves risks, including the potential loss of principal. Past performance is not indicative of future results. The content presented here is based on sources believed to be reliable, but we cannot guarantee its accuracy, completeness, or suitability for any particular purpose. Any investment decisions made based on the information in this presentation are solely at the discretion of the individual investor. We do not endorse or recommend any specific investment product, strategy, or service. Investors should conduct their own research and seek the advice of a qualified financial advisor before making any investment decisions. We disclaim any liability for any loss or damage arising from reliance on the information provided in this presentation.
