The good, the bad and the ugly

At Finance Forward, I presented on the intrigue that has enveloped bond markets. The epic spaghetti western presents a neat means to compartmentalise the drivers of higher long end rates into distinct buckets, even though they in fact are acting in unison.

I started out by noting that the rise in long end Treasury yield really kicked off with the outbreak of the Iran War. The consequent spike in energy prices delivered higher inflation; in the US, headline inflation hit 4.2%, and is now at 3.7%. Far too high for comfort. Hence the subsequent 25bp Fed hike, and the expectation for more ahead. Bond markets hate inflation, so yields are up.

Then again, the 10yr Treasury yield is a complicated beast. If we break it out between inflation expectations and real rates, we find that most of the rise in yields has actually from higher real rates. Inflation expectations have remained remarkably well contained. How to rationalise this?

Let’s start with the good – the AI revolution. There is an important theoretical link between productivity growth and the real interest rate. To the extent that the AI spend results in a productivity boom, that can explain upward pressure on real rates. We don’t think this is the largest impulse, but we do think it’s there, and it’s meaningful. Long duration AI relative issuance has also been a pressure, but we’d view the productivity piece as more impactful.

The Bad is the fiscal deficit. In the US, it came in at just under $2trn for FY 2026, and remains at a troubling 6+% of GDP.  The good news is it’s not getting materially worse. But Treasuries also know it’s not getting better either. The fiscal deficit can also place upward pressure on real rates, as investors demand a higher compensation for holding them. One small positive here is swap spreads have remained relatively well contained, implying that we’ve not had a big negative hit on Treasuries.

The ugly is the War, and more pertinent for bonds, inflation. We think this accounts for about 50% of the upside pressure for rates, with a lot of this coming through on a higher risk premium. Then about 30% is deficit pressure, with the remaining 20% reflective of the AI boom impact (mostly productivity).

We find that the US economy is quite boomie in places (AI/corporate America), but quite stressed in others (the median consumer). The central market discount has the Federal Reserve hiking rates to at least 4.75%. What is less likely is the market discount for the funds rate to stay elevated at 4.75% for the next 10 years (on average). This seems overdone. We’d have a more benign view, where the Fed does not hike as much, and subsequently cuts back down to the 4% area, or lower. The pressure for higher bond yields will remain over the coming months and into Q1 2027. So back up to the 5.25% - 5.5% zone first. But beyond that, we’d expect to see a calming, with the 10yr yield getting back down to 4.75% through 2027. Swap spreads should be wider though; Treasuries should cheapen vs SOFR.